Interview

«Betting on Bond Yields Falling Further Is Like Picking up Nickels in Front of a Steam Roller»

Lyn Alden, the founder of Lyn Alden Investment Strategy, is not very bullish on US stocks over the coming years. As bonds are also expensive, investors need to adjust their portfolios to preserve their wealth.

Sandro Rosa
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Financial markets are caught between the US elections and a new wave of Covid-19-infections on one side, and central bank and fiscal stimulus on the other. Investors lack conviction, and for some weeks now, stock markets have been trending sideways.

Investment strategist Lyn Alden is not very optimistic on the longer term outlook for the S&P 500. «Historically, every time stock valuations and household allocations to equities were this high, returns over the following 10 years haven’t been very good», she says in an in-depth conversation with The Market.

Furthermore, she explains why she thinks investors are too focused on the presidential race even though the senate is much more important. She says which international stock markets are attractive and why she holds a small portion of her portfolio in Bitcoin. Given the very low bond yields, she recommends investors shift part of their portfolio’s fixed income portion into gold.

Mrs. Alden, the most important topic for financial markets at the moment are the US elections. Does it really matter who will win the election?

I think somewhat less than people believe and also possibly in different ways. A lot of the attention focuses on the Biden versus Trump election and there is less emphasis placed on which party is going to take control of the Senate. And that’s a very close race at the moment, which is why I am focussing the most on the Senate.

Why is the Senate more important?

Because if you get a conflicted situation where Biden wins the presidency but the Senate stays Republican, then you’re going to get a lot of gridlock. Which means that Biden would have difficulties passing things, and that increases the odds of a smaller stimulus bill which will create a more disinflationary environment.

So any outcome would be positive for the market as long as one party scores a clear victory?

Yes, I think so. The bigger the stimulus, the bigger a currency devaluation you get, which would lead to reflation, as prices would rise in that scenario. Whereas if you get less stimulus, disinflation and solvency issues will continue. Now, the hard part about elections is first you need to be right about the outcome and you also need to be right about the market’s response to that outcome. That’s why I don’t try too hard to tie the election outlook into my investment outlook. Instead I focus more on specific policies such as whether there will be a stimulus or not and whether it will come pre- or post-election.

Is there any doubt that there will be another round of stimulus in the US, given the weak state of the economy?

I think there will be a stimulus, but it is a question of size. The Republicans were interested in a stimulus package of $500bn in the Senate, which is a much smaller bill than the Democrats proposed. The Republicans, however, don’t want a particularly large stimulus as there are many fiscal conservatives in that section. But it is not necessarily a partisan thing. Donald Trump, for instance, also wants a very large stimulus. Having a $3 trillion stimulus is very different from a 500-billion stimulus package. The timing is also important.

Despite the difficult economic situation and the rise of Covid-19-infections, stocks have done very well. Have equities detached from reality, and how is this going to end?

Probably not well in the long-term. Given current valuation levels, I do believe the US stock market is likely to face headwinds in the coming five years. Historically, every time stock valuations and household allocations to equities were this high, returns over the following ten years usually haven’t been very good. The trouble with identifying a bubble though is that it is hard to time the top. For example, back in 1997 and 1998 stocks looked expensive but over the following two to three years they got even more expensive before they eventually came back down. Ever since around 2017 the stock market has been kind of frothy. But instead of pulling out it was about finding areas that are less overvalued or finding companies that could do well regardless and diversifying internationally.

Which international markets should one diversify into?

I am somewhat bullish on Japanese equities, but also certain emerging markets equities. I think some of the Chinese internet stocks such as Tencent and JD.com as well as the beaten-down Russian commodity producers and banks are also attractive. There is some value in India as well. India is never cheap, but compared to the growth rate and compared to the fairly low debt levels, Indian stocks are a good diversifier. I haven’t been thrilled about European markets, however.

European stocks haven’t made any progress over the last ten years. Aren’t they cheap?

I have invested in individual stocks in Europe and I have a small slice of the regional index, but I am waiting to see what happens there with fiscal stimulus. As the countries of the European Union have to agree on measures, this adds an extra layer of complexity and uncertainty. So far, Europe has had more disinflation and slower growth overall. True, given the underperformance, equity valuations are a bit more attractive and ultimately there will be some pretty significant stimulus. However, the timing is more uncertain in Europe.

You mentioned the performance gap between the US and the rest of the world. But there is also a gap between sectors such as technology and energy. Is that rational or dangerous?

I think it is dangerous. There are so many companies that got pounded this year and so investors have flocked to the companies that have done well, as they perceive them as less risky. However, by doing so, they have pushed valuations high enough to make them risky as well. For many of these stocks, valuations went up parabolically. That’s what we saw with Apple and Microsoft. There are some niche players where the fundamentals also went parabolic, because their business is suited for the pandemic. But for the most part investors just piled into companies that were not harmed by Covid-19.

And due to Covid-19, interest rates also fell further.

Yes, growth stocks also do better in a low-interest environment, and due to the crisis, interest rates went even lower. In short, growth stocks benefited from every possible tailwind. Consequently, I have been trimming my exposure to technology stocks. I trimmed Nvidia and I trimmed Adobe, even though I don’t like selling quality companies. They just got to a point where I had to shift some money into laggards.

Which laggards are attractive?

You know, I don’t want to go out and invest in the lowest quality energy producers, but putting some money into energy companies in the best quality decile – the ones with the strongest balance sheets, the lowest production costs, the biggest reserves and the best management – makes sense. I also invested a little bit in pipelines as they are less concerned about the energy prices and more concerned about the volume. As long as they can move oil and gas, they are doing pretty well. And their valuations are at a ten-year low. So, I have been slowly allocating more in these beaten-down sectors.

We have seen massive stimulus and massive interventions by central banks. What are the consequences of these measures?

The long-term outcome is probably some degree of currency devaluation, which could take the form of inflation.

Are you talking specifically about the Dollar?

The Dollar in particular, but I think the currencies and sovereign bonds of many countries around the world are likely not to do very well in real terms. I have been bearish on the Dollar since October 2019 and I think that in the next several years we will see a further decline in the Dollar Index, but it is somewhat dependent on the timing of stimulus measures. If we get a bigger stimulus we get more reflation and are likely to see a quicker down move in the Dollar. However, if there is no stimulus, if there is gridlock that scenario could take longer to play out.

We have also witnessed a sharp increase in debt levels.

Basically, with sovereign debt at this level, the US can’t afford to have interest rates rise. Today we have a similar environment as in the 1940s, when we had a massive debt build-up due to World War Two. Relative to the size of the economy, there was so much debt in the system that private buyers could not buy it all anymore. As a consequence, the Federal Reserve started to buy a lot of those Treasuries and had the banking system absorb a lot of it as well. And then the Fed kept the interest rates on these Treasuries low. It made use of the fact that it could buy any number of Treasuries to basically peg their yield at 2,5% or below. Throughout the 1940s we had pretty substantial inflation. Even though by the end of the decade bond holders got their money back, on a real basis they lost about a third of their purchasing power.

While fixing the interest rate seems to be easy, getting higher inflation is much harder to achieve.

It depends on the stimulus. Monetary policy itself is not very inflationary because all it does is recapitalize the banking system and build up reserves in the system but it does not directly increase the broad money supply. However, when the government resorts to fiscal stimulus, either in the form of spending or with unfunded tax cuts, it increases the broad money supply. Especially when you have that situation when they are not extracting it from the same population, but have the central bank buying sovereign bonds using brand new currency.

What’s the consequence?

Historically, massive fiscal deficits combined with some sort of yield curve control leads to a lower currency being the release valve. So that’s definitely something to watch for, especially because right up to that point long-term bonds generally look like one of the best investments to be in. But when there is a sea change that leads to a devaluation of the currency, that’s the point when those kinds of instruments are more at risk.

Does that mean the forty year bull market in treasuries is over?

It remains to be seen if there will be another leg down, but I think that it is quite possible that the big March downdraft in yields was the bottom. Now we are seeing a gradual uptick but I can imagine another leg lower if we get gridlock and there is no stimulus. Unemployment is still high, as are debt levels and there is the risk of another solvency event, which could send yields lower again. However, that is not a trade I want to do right now. That’s like picking up nickels in front of a steam roller. The risk-reward is just not attractive.

That’s a difficult situation for investors. How can they protect their wealth given expensive stocks and even more expensive bonds?

One strategy is to take a part of the bond portion of your portfolio and put it into gold. Instead of a 60% equity and 40% bond portfolio you create a 60/30/10-portfolio where you put ten percent into gold, which tends to do better in an environment where interest rates are below the inflation rate. In addition, if you diversify the 60% equity portion internationally, you can mitigate some of the high valuation problems, as emerging markets and Japanese equities are certainly not expensive. Since April I have also been highlighting the value of having a small position of 1-2% in Bitcoin. If it does poorly, only a small portion is at risk, but it has the potential of going up five- or tenfold.

What exactly is the case for Bitcoin?

It has a growing network effect. Even though there are thousands of cryptocurrencies, Bitcoin has a first-mover advantage. It makes up a large percentage of the entire cryptocurrency market as it offers the highest security. If someone tries to attack one of the smaller cryptocurrencies they can succeed whereas the cost and difficulty of trying to attack Bitcoin would cost billions of dollars and probably would not succeed. Furthermore, we are seeing more and more ecosystems being built around it. For example, Square’s Cash App let’s you buy Bitcoin, Paypal just announced the same – and these big companies all choose Bitcoin or one of the four largest cryptocurrencies. They don’t care about the other 5000 currencies.

And the number of Bitcoins is limited.

Indeed, there is a fixed number of Bitcoins. Every four years the number of new Bitcoins created every ten minutes gets cut in half – that’s called a halving. And historically, over that four year cycle, the first half of that cycle is when all of Bitcoin’s bullish action happens. After halving, demand still comes in but new supply is reduced. So, if a large portion of the existing supply is not moving, which is usually the case, then that additional demand is up against a smaller new supply of coins. That leads to these crazy bull moves. Where we are in the halving cycle is pretty attractive.

Gold supply is also growing only slowly.

Yes, but it lacks portability. I like gold, but if you like to transport gold internationally, you quickly run into problems. As for Bitcoin, you can transfer any amount internationally very easily and there is not a lot authorities can do about it. With a very small device you can bring any amount of money through an airport. Or just by remembering a seed phrase, by remembering just 12 words, you can bring any amount over a border and you can reconstruct your ability to access your Bitcoins later. There is a utility in this, especially in emerging markets where currencies fail or sovereign bonds lose their value. That’s why we have seen a growing interest in Bitcoin in Turkey and some countries in South America. If some bigger markets move towards outright yield curve control we could see an uptick in interest there as well.

What about the attempt of central banks at creating digital currencies. Does that change the case for bitcoin?

As with any fiat currency there is no limit to how much central banks can print. Bitcoin is inherently scarce and out of the control of central banks and for people who like that network effect that’s appealing. Now, central bank digital currencies give the authorities all kinds of different tools. For instance, with digital money it would be much easier to implement negative nominal interest rates and central banks could pursue a much more targeted monetary policy. In some ways, that’s the exact opposite of Bitcoin. While central bank digital money allows for greater control by authorities, Bitcoin – along with gold – allows you to opt out of some of that.

Lyn Alden

Lyn Alden, the founder of Lyn Alden Investment Strategy, provides investment research for retail and institutional investors. With a background that blends engineering and finance, her process involves fundamental investing with a global macro overlay, with expertise in equities and alternative asset classes. Lyn has a Bachelor's degree in electrical and electronics engineering and a Master's degree in engineering management with a focus on financial modeling and engineering economics. Her specialties include monitoring developments in the business cycle, analyzing various approaches to asset allocation, and covering stocks and international ETFs, focusing strongly on valuation.
Lyn Alden, the founder of Lyn Alden Investment Strategy, provides investment research for retail and institutional investors. With a background that blends engineering and finance, her process involves fundamental investing with a global macro overlay, with expertise in equities and alternative asset classes. Lyn has a Bachelor's degree in electrical and electronics engineering and a Master's degree in engineering management with a focus on financial modeling and engineering economics. Her specialties include monitoring developments in the business cycle, analyzing various approaches to asset allocation, and covering stocks and international ETFs, focusing strongly on valuation.