Episode #473: Jeroen Blokland, True Insights – Multi Asset Masterclass
Guest: Jeroen Blokland is founder or True Insights, an independent research provider, and previously spent over a decade at Robeco.
Date Recorded: 3/22/2023 | Run-Time: 1:00:58
Summary: Today’s episode kicks off with an overview of the recent stress we’ve seen in financial markets and the implications for your portfolio. He shares why he’s cautious but not bearish, and why he agrees with recent guest Mike Wilson that the earnings recession isn’t priced in yet. We also touch on the role of gold in portfolios, the set up for high yield bonds, and why he thinks the housing market may see a steep decline in the next year.
Earlier this year we sent out a preview of his work at True Insights on The Idea Farm, which you can review here.
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Links from the Episode:
- 2:40 – Welcome to our guest, Jeroen Blokland
- 3:47 – Overview of Jeroen’s investment framework
- 7:40 – Whether or not we’re actually in a systemic banking crisis
- 17:41 – Investible implications of the current market environment
- 25:03 – Takeaways from market sentiment around equities
- 27:37 – How to think about gold in 2023 and indicators he prefers
- 34:33 – Sectors Jeroen’s currently bullish and bearish on
- 40:02 – Broad characteristics and differentiations between developed market and emerging market equities
- 43:38 – His perspective on housing today
- 49:40 – What he finds intriguing about high yield bonds
- 53:35 – Things he’s thinking about he looks out to the horizon
- 56:11 – His most memorable investment
- 58:04 – Learn more about Jeroen; true-insights.net; Twitter; Newsletter Sampler
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Now back to the show.
What’s up, everybody? We have a multi-asset master class for you today. Our guest is Jeroen Blokland, founder of True Insights, an independent research provider, and he previously spent over a decade at Robeco. Today’s episode kicks off with an overview of the recent stress we’ve seen in financial markets and the implications for your portfolio. He shares why he is cautious but not bearish and why he agrees with recent guests, Mike Wilson, that the earnings recession isn’t priced in yet. We also touch on the role of golden portfolios, the setup for high yield bonds and why he thinks the housing market may see a steep decline in the next year.
Earlier this year, we sent out a preview of his work, a True Insights on the Idea Farm. So if, for some reason you haven’t subscribed yet, be sure to check the link in the show notes for some of his recent research notes. Please enjoy this episode with True Insights’ Jeroen Blokland.
Jeroen, welcome to the show.
Yes, hi, Meb. Good to be here.
Where’s here? Where do we find you today?
I live in Rotterdam which is not Amsterdam, I always have to say. So it’s the other big city in the Netherlands.
Yeah. So we’re recording this late March. What’s the vibe there right now? What’s going on?
No, not much. So it’s cold, it’s rainy. For weather purposes, Rotterdam is not the best place to be.
Sweet. Well, I want to come visit sometimes, so I’ll put it on the list. Never been.
Yeah, it is a good city to do a lot of cultural stuff and do some partying if you want to, some sightseeing. That’s good. That’s good.
Are you a native? Is this your part of the world originally?
Yes, yes. And from really close by actually, yes. So my parents were born in a city that is very close to Rotterdam and all of these cities, there is no beginning and there’s no end. So they are one big conglomerate. It has a different name, but everything is Rotterdam.
Very cool. Well, look, we’re going to dive into all things markets here. I mean we’re going to touch on a lot, housing, banks, inflation indicators, yada yada. Before we get started, let’s hear a little bit about your framework. I know you are ex-Robeco, Robeco, depending on where you’re from. We probably have had more alums from that company on the podcast than just about anybody. Give us a little overview on your kind of framework, how you think about the world of investing in general. What’s the lens you view everything?
So whenever I get this question, my answer is always as first, that I think there’s more than macro to invest. So I get a bit tired of all these people that try to explain all market developments by central banks or by macroeconomic data. Of course, they are important and when you talk about central banks, you are also talking about liquidity which is very important. But if you look for example to last year, 2022, there was this continuous fight between markets and central banks. So in the end, power won, because central banks they continued to hiking rates and it was the market which had to adjust. And that means that other factors that I include and sentiment is also important there because why are markets sometimes moving which is not in line with what you would expect if you look at macroeconomic data as well.
So I look at a lot of sentiment indicators from the fixed index to moving averages, relative strength index. We have developed our own fear and frenzy sentiment index to make these underlying sentiment indicators work when they actually tell you something about future returns and not because it’s a nice bull or bear market indicator. And the third pillar next to macro sentiment is valuation and then especially relative valuation. So I want to know if equities are expensive relative to high yields or to commodities because when things are looking up and it’s risk on, you can still have a poor performance if you choose the wrong one. So I want to know which of these risky asset class I have to overweight or I have to add. And the same, of course, if things are risk off, which is then the best risk return trade off. And that is also an area where valuation comes in. And you see, especially now, if you also look at some of the volatility indicators, that there’s a big difference between if you are looking at volatility in both markets or in equity markets.
So for me that is both a sentiment but also a kind of relative valuation indicator. If you believe that what is driving markets is the same for bonds and equities, for example, central banks, then you should expect that if things change on the outlook of central banks, that will have impact on both asset classes and on both volatility measures. Now, you can see if you look at the move index or the fixed index, they’re worlds apart.
So I try to combine macro sentiment evaluation, and basically it’s very straightforward. By ticking the boxes of this framework so I look at the same kind of indicators every time, I hope that I can tick enough boxes that send me in the right direction to either overweight equities or commodities or government bonds. And by doing that over and over and over again, I hope to increase my hit ratio to 60%, which is very, very high. And that is basically what I try to do. I’m not able to find the peaks or the lows, but if I can find or I can add the right asset class in half of every [inaudible 00:07:27], then I’m more than happy. So that is what I try to do, these elements of these three pillars, combine them and then decide which asset classes you should overweight and underweight in your portfolio.
Well, good. Let’s dig in. That was a lot. I love it. It’s funny because you were talking about the Fed and central banks and I feel a lot of the time people sort of ignore them and then they become the topic of the day and everyone’s focused on the Fed and Elon Musk is talking about the Fed Funds Rate and then years will go where people aren’t even thinking about central banks in general. But should we start with the banking sector? What do you want to begin with? Because we got a lot of ground to cover.
Yeah, I think the banking sector, because it’s such topical so let’s start there. And I did a little piece, it’s not published yet, but on the question is this actually a systemic banking crisis? And what I find interesting is that a lot of pundits, experts, whatever on Twitter, on LinkedIn, wherever, on radio, TV, whatever, they have an opinion. And most of the time, because this is so uncertain, it’s a gut feeling. It’s an idea they have or an assumption they make. But actually there are a couple of empirical databases that you can use to determine if this is a systemic banking crisis. If not, then most probably the outlook for risky asset is much better of course than if it is or if it becomes one. So I did some fact checking on where we are in this cycle and what that potentially means for monetary policy of course and outlook for different markets.
Well, it’s here. What was it?
Yeah, so there’s this big database. It’s called Laeven and Valencia. It’s like Reinhart and Rogoff. They focused on banking crisis historically and they do an update every few years, and then basically they say there are two conditions that have to be met to determine if something is a systemic banking crisis.
The first condition is that significant signs of financial distress in the banking system has to be visible and they add then as indicated by significant bank runs, losses in the banking system and/or bank liquidations. Now, I think if you look at what happened in recent weeks, you could I think argue that this condition is met because we have seen bank runs and we all are aware of this FDIC chart showing the unrealized losses that then became realized losses because of the deposit outflows of the banks of over $600 billion U.S. dollars. So I think the first condition is yes.
And then the second is have we seen significant banking policy intervention measures in response to significant losses in the banking system? Now, Laeven and Valencia, they have five or six different criteria to determine if there is significant policy intervention, extensive liquidity supports and that means, apart from guaranteeing depositors, but is there liquidity to financial institutions directly of 5% of deposits or more. They look at bank restructuring costs, they look at bank nationalization guarantees, significant asset purchases and deposit freezes, which almost never happens in developed markets.
If you look at the US, I think zero of these conditions are truly ticked and if you look in the case of Switzerland, Credit Suisse, but also the size of the guarantees up to a hundred billion Swiss franc in support loans, liquidity loans, also some more guarantees if there are losses because some skeleton comes out of the closet of Credit Suisse, there you can I think tick two boxes, that of the guarantees and the liquidity supports. But overall, if you take this framework, their framework, as let’s say your guidance, your methodology to determine if this is a systemic banking crisis, then that is not the case.
So that is my conclusion also of my piece. If I look thoroughly at all these criteria they put out and they checked it historically, then my conclusion is no, this is not a systemic banking crisis. The question, of course, is then will it become one? But at this point, so all these people who say this is systemic, they don’t necessarily back it up with empirical evidence and this database does and that is why it’s so nice. It also looks at 150 banking crisis. Basically, their story is you see the same type of reaction, policy intervention coming back all the time. And these are these six criteria I mentioned or I read aloud because I didn’t know them by heart yet.
Cool. Well, that’s in show note links. That’s really interesting. And, by the way listeners, we’ll talk about this more as we go on, but Jeroen has a great newsletter that we have featured on the Idea Farm as other places and also what’s the best website for you? Where do people find your writings?
It’s true-insights.net, so true-insights.net. If you type that, you will visit my website and there I will explain what we do and you can also get a free trial. Of course, you can subscribe. There are a couple of examples like we did in the newsletter with you guys. So you get quite a decent information on what we do. Of course, I write stories about financial markets, but almost every piece it has to include a conclusion on what to do with that in your own portfolio. So should I change something or not? But that is basically the idea. The things that I see and other people see, we describe it but then we want to have an actionable conclusion added to that.
He’s also great on Twitter, so we’ll post your Twitter handle, jsblokland, as well. So we shouldn’t be sweating the banks a systemic failure just yet. Maybe at some point, but not yet.
Where do we go from there? What’s like the next thing that’s on your mind that you’re thinking about as everyone is focused on the banks?
Yeah, so then I think if this [inaudible 00:13:38] is banking uncertainty, I think that is a little bit too early because if I look at what the Federal Reserve, the US Treasury and the FDIC have done now, I was in a Twitter space recently and somebody mentioned this is a whack-a-mole again. And I think that is really true because you have regional banks coming in taking deposits from failing regional banks. Then you have national banks coming in taking part of deposits of these regional banks. But the whole, let’s say, dynamic of these unrealized losses and the deposit outflows because they face competition from money market funds and also some of these like Silicon Valley are in industries that their clients have really fast cash burns, there’s no overarching solution just yet. So I think we have now First Republic Bank. I think there has to be another liquidity boost to, let’s say, have a more overarching impact on the regional banking sector.
And so I think it’s too early to say that will stop now, but then immediately that brings to mind of course what is the Federal Reserve going to do. And I changed my mind a little bit here. So until March 8th before this whole Silicon Valley Bank thing started, I was really, really focused on the underlying inflation levels. So we have a US inflation monitor and, again, also to debunk some of the beliefs that are out there. So everybody’s now focused on these three-month analyzed core services, ex shelter, ex housing numbers. In addition, a lot of people also look of course at core inflation and then some others. So I look at sticky prices of the Atlanta Fed and we also have medium prices. Now, the interesting part was I think everybody has forgotten that by now, but all of these, all of these, so I look at seven different of these inflation indicators, these seven indicators, the three month analyzed inflation rate accelerated for two months in a row.
So it did not only come down less than expected. So that was first the narrative, “But it’s still coming down.” No, they accelerated. They accelerated. And that is also why at some point a small part of the market was pricing in a Fed Funds target rate of 6.5%. And even though I don’t think we would have gone there, but you see this and this will be the interesting thing, how much attention is Powell going to pay to what happened before March 8th because then all the inflation data were higher than expected and accelerating some of them and the seven that we looked at in the monitor, all of them. And at some point does he allow for a potential pause because I don’t think we will see rates good any time soon, but will he allow for a pause. I can imagine that he would do that because it buys you six weeks until May 3rd. That’s the next FOMC meeting and still you can have the same message.
By then if everything has died down and things are back to normal-ish, then we go on with our 25 basis point hikes as long as necessary and we have these inflation numbers. Now, I think the market is now expecting 80% to show that we will get a 25 basis point already in March. My question would be if he does that, what will happen to short term and longer term but also short term interest rates who are at the core of what happened to the unrealized losses of these regional banks which have no overarching solution. So that is my angle how I look at what Powell is doing or has to do. And I think he’s between [foreign language 00:17:23], a rock and a hard place. This is really difficult and I was very firm on hiking by 25 basis point and at least six times or so, but now I could imagine that he pauses this time only to go on next time.
Well, we’ll find out. As we start to think about some of the kind of investible implications about where we are, so very different environment than the majority of our careers what’s happening this year, but certainly some similarities with what’s happened in the past. Where should we go next? You talk about markets in general. You mentioned the VICs, you mentioned the move index which listeners may or may not know what that is. Where do your binoculars take us next?
Now maybe a little bit on positioning then. So if you look at the three pillars of the framework, macro sentiment and valuation, there are a couple of things that stand out for me.
The first is that, even though the underlying indicators have improved somewhat, I won’t go into the specific details, but the ISM manufacturing index is still, if you look at these indicators, it still suggests that it will go down. And also, because of the recent development in banks, so the regional banks they give out more than half of industrial loans and things like that. They are very important for the credit growth in the United States. Now, I can imagine that if you are a customer of one of these banks that has now failed, that your confidence has not improved. So I can imagine that the ISM manufacturing index also is negatively impacted by this banking crisis at the point that it is already below 50 and it is supposed to go down further.
Now, what you see historically, and again this is connecting the dots and going a little bit further than most people on Twitter for example, so there are a couple of things. You have this year-on-year relationship, year-on-year changes in the S & P 500 index are very closely correlated to the ISM manufacturing. Now, that is one thing, but you can also do that for US Treasuries and also for commodities and also for high yield bonds. And then you can, let’s say, use a simple regression and look at the relationship between the end because it also matters what happened a year ago because it’s a year-on-year change. A lot of people tend to forget that if you look at only the chart [inaudible 00:19:51]. Now you see then the ISM manufacturing basically has to rise to provide any upside from this historical relationship for US equities, for example. So I think the ISM manufacturing will go down and that means from this, only this downside for equities and also for high yield bonds and upside for US Treasuries.
The second thing is you can look at ISM manufacturing regimes and whenever the ISM manufacturing is falling, it doesn’t matter from what level, 60, 50, 40, but if it’s falling, the three months forward returns only equities for example are below average and in some cases negative, whereas if we are at 40, 50 or 60 and we are rising, most of the time then the S&P 500 index realizes above efforts return. So the ISM manufacturing is one of the key observations but in a multi-asset context and that is where I worry about upsides for equities from this perspective.
And then if you look at the sentiment pillar, and let’s focus on equities because most people think about equities of course most, we have this fear and frenzy sentiment index and what that does, for example, we look at the moving efforts and then we determine when this moving average says something about future returns. And again, the focus is on three months, but we extend that to 12 months. And basically it’s very simple. The moving average is very straightforward because if you are trading below the moving average, then the S&P realizes on average, of course, a negative return and a positive return when it’s trading above that.
So whenever the S&P 500 index falls below the 200-day moving average like it did a couple of weeks ago, then an alarm bell goes off. And from the sentiment side, this is a negative for equities. Now, we do that for 11 different indicators and then we have this overall sentiment index, the fear and frenzy index. And what makes it better, I think it’s better of course, than the [inaudible 00:21:50] Bull Bear or whatever I’ve seen, there’s an empirical backing behind it.
So for example, the relative strength index, everybody watches the level 70 and the level 30. So when it’s 70, we say it’s overbought, the S&P 500 index is overbought and you should sell. And when it’s below 30, then we say the S&P 500 index is oversold and we should buy. But if you look at the return dispersion, what happens if we go above 70, three months later on average the S&P 500 index return is marginally better than the average. Marginally. So same risk and so on. But if it goes below 30, then it’s when the magic happens. So then the future three- month return on equities is much, much higher than the average. So even though everybody treats 70 and 30 levels as the same, empirically this is not the way to do. So we assign weights so the relative strength index gets a lot of points in the index or weight in the index if it’s below 30, but not that much when it’s trading above 70 because historically the forecasting power, let me put it like that, is less than the 30 level.
And I think this asymmetry, nobody cares. Everybody looks at these extreme levels the same and there number of examples. So you have to incorporate these sentiment indicators wherever they have power, whenever they tell you something about future returns, and that overall index is actually pretty cautious. So it’s near fear. And this is I think one explanation, liquidity is another of course, why stock markets are not dropping like 10% or so on this banking crisis issue because sentiment was already pretty meager, pretty downbeat.
And then finally from the positioning side, why I’m cautious on equities and there was another example of that again. So, I truly believe in an earnings recession. So no matter what if we get a recession or not at US, I think the odds are still a little bit high that we will than that we won’t. But an earnings recession I think it’s very difficult to escape that. And yesterday we got South Korean export numbers. South Korea is a bellwether for the global economy and its export levels are a very good indication on where global earnings per share are going.
Now if you look at the charts, I can send it to you if you want to add it, but you see it points to a 20-25% year-on-year decline in global earnings. And also, if you look at history, every time we had a recession but also every time we had a major economic slowdown, global earnings per share fell like 20% and sometimes even more. So this whole story that we will go out with 2022 basically flat or 2% or 3% decline and then we start to move higher again, I don’t believe that and I think that there’s a big risk because if you then do a PE versus earnings per share combination, where can we go, actually a lot of downside stock markets even though it’s less than a couple of months ago because the PE ratio, the valuation of equities has declined somewhat. So I think this is maybe also a good way to express how I look at the framework and then to asset classes. So this is a little bit how we do it.
Good. So that was a lot in there. When you think about equities in kind of the positioning you mentioned, where does sentiment fall in? Is it something that you’re kind of looking at equities and sentiment is obviously something that’s generally kind of squishy but we try to quantify it. What do you feel like the sentiment around the equities is in general? Is there any easy takeaways we can make from that?
No, if you look at this fear and frenzy sentiment index, you cannot say that equity investors are exuberant, that they are somewhat cautious. On the other hand, we also look at traditional momentum data, so one, three months and 12 month momentum and these are not that great of course, especially the 12-month momentum. And basically there are three elements. So momentum, it’s still no. If you look at sentiment indicators like I described, it’s okay, could be, could be. And then you have positioning and if you look at things like the Global Fund Manager Survey of Bank of America and there are a couple of others that we look at, it seems that equity positioning is light. So that is also why I’m cautious but I’m not extremely bearish. So this whole sentiment part I think is the better part of the framework than the other parts, the macro and the valuation parts of the framework.
So yeah, sentiment and even I think if it would drop 5% from here, most likely this fear and frenzy index will go into fear and then you get a rebound. So yeah, I think it’s pretty decent. It’s really waiting for these three months and 12 months momentum to turn because they have been negative for so long and for all asset classes except for commodities but there’s also negative now. The only one that is still standing is gold. All the other ones are in the wrong quadrant of the momentum.
Yeah, I hear you. We’ve been talking about this a little bit. Always curious about gold. It’s an asset class, investment, whatever you want to characterize that that I feel like we haven’t heard as much about in the past 10-15 years really, or at least the sentiment seems to be quiet. Maybe all the crypto took all the air out of the room in this concept of where gold usually falls, but nothing like rising prices to cure that. And as you mentioned, the precious metals have been rotating into a lot of our momentum models over the past number of months. We’ll be curious to see what happens there because they’ve been quiet for a long time. The bugs have been silent, so we’ll see.
While we’re on gold, I mean how do you think about it? Is this purely … You do so much involving macro indicators, thinking about a lot of these sort of complimentary ideas. I mean you spoke to the 200-day just right to my heart there, love it. But others that we haven’t spent that much time on, a couple of podcasts on ISM and others. When it comes to something like gold, how do you think about it? Is it purely price-based? Can you start to think about in terms of some of the indicators particularly helpful when it comes to gold?
So gold to me, first of all, is a very specific asset class and since I’m a multi-asset investor, I don’t have 3,000 individual stocks I can pick from. So the more, the merrier. So I can choose from 12, maybe 15, but then basically all the major asset classes are covered. And if you look at the risk-return characteristics of gold, it’s a perfect, not perfect, but it’s a very good diversifier. So that’s my first thing before I have any, let’s say, tactical view or long-term view on that. That is one thing.
And also if you look at it, it is perceived as an inflation hedge. Its volatility is 70%, so it has nothing to do with inflation or the inflation index, but over time it beats inflation with different characteristics than bonds and equities which also beat inflation. I think that is also something that you should add. When you are talking to somebody that is very interested in gold, they forget that bonds and equities also beat inflation in the long run. And so it’s not that these other asset classes are bad, not in the least because they provide some kind of income, dividends or coupons, of course.
The second thing is that, and I think this is strengthening and this is also one reason why it’s becoming more popular again, I’m well aware that a lot of people see gold as, let’s say, the traditional go-to risk of assets if you believe that something will break in the current monetary system, and that can be extremes. I don’t like the extremes, but it can also be the depreciation of your currency, the negative impact of inflation of course, now to really like the end of the world and the monetary and what we are doing with the central bank balance sheets that cannot go on forever. There’s too much depth in the system. We go back to a non-Fiat currency system, whatever, but there’s a large group of investors and that means, at least to me, that gold reflects some kind of general, and that’s different for every investor, but insurance premium.
And you can also quantify that if you look at the ratio, and a lot of people do that, between the price of gold and the price of silver and you relate that to how much gold is on the planet and how much silver there is on the planet. Then you see that gold is massively overvalued from that perspective. So if all these precious metals would be efficient to let’s say their output, how much is there available supply, then gold must be much cheaper or silver must be much more expensive. There are also a lot of people who think that should be the case, but let’s not go there now. But I think that is a very clear and empirical substantiated proof that there is some kind of insurance premium. And then the question is, of course, do you believe that this insurance premium is right, is valid, or are you of the term an assets class can only have value if there’s a stream of income. Of course, you immediately get into this discussion. There’s no way out of that discussion because everybody wins if you substantiate it in the right way.
But that for me is what gold represents. And you also see this clear correlation. Of course, everybody know now with real yields or with real bond yields, there’s extremely strong correlation. So when real yields go down, this is the whole financial suppression angle. Of course, then gold goes up. Now I think, apart from financial suppression, but if you look at the issue of debt sustainability, there are a couple of things that you can do. You can reduce fiscal stimulus or no longer run budget deficits, but we know that our economy and our growth model is driven by debt. And so it’s a debt driven growth model. So if we all agree that we don’t have any budget deficits anymore, then you have to agree that we don’t want to have any growth anymore. A much more easy way is to say let’s keep interest rates low and inflation may be a little bit higher. This is where this 3% target comes from. Let’s move it from 2% to 3%. That buys us time because debt sustainability is then pushed down the road again.
So I also think there are, let’s say, general forces that most likely end up in a relatively low or negative real yield. And this is also why gold comes into play, of course. So these are for me the key arguments to consider gold in your portfolio. Having said that, I do think that real assets in general are underrepresented in most portfolio, but it’s not the case that I say that you should have 50% of your portfolio in gold. So I think there’s also something as what is the relative market cap, the relative size of all these asset classes. So yes, I have gold in the asset class portfolios and in the asset allocation, but not to the extent that some of the gold books that you mentioned have. So I think that is something to add to the discussion, that the key asset classes in my portfolio are equities and bonds.
So gold, we joke on this show a lot, we say it’s kind of like your crazy cousin who shows up for a family holiday. What is Eddie going to be like this year? Is he going to be the nice cousin who brings gifts and is thoughtful and helps take out the trash or is he going to be the one drinking all the eggnog and just gets hammered and takes off his pants in the middle of the party? You just never know. And so gold to me is fairly unique. I always say you can’t really count on it. I mean you can’t really count on any asset class to necessarily behave as far as the correlations, right? I feel like a big surprise to many allocators last year was, “Hey, I thought bonds and stocks always zigged and zagged.” And if you study history, they don’t, right? Sometimes they don’t.
And so gold to me is like it’s just a total unknown. And so we love it and have always included it but you can’t count on it. And also you mentioned what I thought was very thoughtful, the negative real yield in a similar context and usually they kind of go hand in hand, the negative or inverted yield curve environment gold tends to have done historically quite well, some decent performance. It’s like you want to be in T-bills, gold and not a whole lot else when things are down around here.
So as with most of my conversations, we’re kind of bouncing around everywhere. One of the things, when you talk about stocks and precious metals, gold miners are like a tiny piece of the stock market, but we often kind of generalize and just talk about the S&P or the broad market cap weighted stock market. But as we know, there’s lots of different sectors. There’s tech and real estate and all sorts of different things that may respond differently to the environment. Is there any areas you’re particularly more bullish or more bearish on? And this can be global too. We haven’t really done a whole lot of US versus the world but, as far as sectors, is there any sectors that you think are more interesting or landmines that we should stay away from?
Not where my highest conviction is currently. So, in general, I think it’s very difficult. We look at it too but to create a sound sector rotation model, let’s call it like that, I think that is very not in the least because some of these companies that are in one sector then decide to do something else or they get categorized in somewhere else like Amazon, for example. So I think when people often say yes, but it’s index composition that determines that US stock market is structurally higher valued than European stock markets. If you go in the sector space, this is of course a very important aspect to take into account. So I find it, in general, one of the most difficult parts to have conviction to say something. Next to that, what you have seen if you look at materials, if you look at oil, energy apart from ESG considerations, of course, but 2022 has very clearly shown is that of course energy prices went up because we have a war in Europe.
But the underlying problem that was commodity sufficiency, security, that was always going to be a problem, especially with all of these sustainability goals which are way too enthusiastic, let me call it like that. So I admire the ambition but a lot of politicians have won votes by screaming what could happen in 2030, 2035 and it was not realistic and that means a massive amount of pressure on commodity supplies in general. And I think what we are seeing now, not distortions but broken down supply chains in combination with geopolitical tensions. There are going to be a lot of different commodity supply chains. So Russia and China, for example, and Europe perhaps with the Middle East, but it’s not always going that great. The US is more sufficient. But all of these things add to the idea a lot of demands, issues with supplies and supply chain changes, let’s call it changes, that most of the time historically leads to higher prices.
So I think, even though a lot of people want to see these sectors shrinking, I don’t think they will do that any time soon. So that is one area I look at. And the second of course, as always, is technology. So we made a round trip after the unprecedented fiscal and monetary stimulus after COVID or during COVID. I’ve dubbed it the Zoom effect in a couple of my pieces. And so the PE ratio of Zoom went to 700s at the peak of this whole extrapolation of we are going to sit behind our desks forever, we are never getting out again. We are going to work from home forever. And that is now the arc is the same. And so we are back now. It was really a round trip. They outperformed like couple of hundred percent some of them and they are now back to earth.
And now of course it’s the question, will the secular teams be strong enough to maintain this, let’s say, earning superiority, growth superiority of this sector. So currently it is not. So for the last, out of my head, six quarters, five or six quarters, the earnings growth of the US tech sector has been less of the overall index, S&P 500 index, and this is for me the clear reason why this devaluation has taken place. Still they’re pretty expensive but they’re not expensive and these companies could not live up to these enormous expectations anymore. And I think if this continues a little bit more, and of course higher interest rates also helps because these are long duration stocks, their sensitivity to rising interest rates was high. This is also reason why recently the NASDAQ outperformed the S&P 500 index, but I was basically waiting for investors to puke on these technology stocks and we were very close, not close enough unfortunately.
And then I think these underlying trends, actually for the market as a whole, as technology as a whole, because I think it’s impossible to find the next Tesla or Amazon or whatever. So for me that is not possible. If you can do it, be my guest. But I was very close on initializing, as they say it, an overweight in this sector and then this whole banking thing and lower rates. But I think technology has some interesting elements to it and that is also why I don’t think it will structurally underperform just yet. So if we have 10 years or 20 years out performance of growth [inaudible 00:39:53] versus value, that can change. But if technology, US technology will underperform structurally, I doubt it.
You got your position across the pond. Any broad characteristics we can make a differentiation between US and foreign developed, Europe, emerging? How much do you look at these various geographic but also relative development stages for equities? Is there any areas that you are particularly more or less interested in?
We are now underweight developed markets equities. And this is because, as I highlighted, growth momentum is going down. Sentiment is not great but not worse. And this whole earnings recession, which I expect is not priced into markets, it definitely is not. So that is the reason that we are underweight.
We are neutral on emerging market equities and this has to do with this whole China reopening trade, of course. So we don’t know how big it will be. We do know that Chinese consumers have excess savings. We do know that China in the region is of extreme importance and it will depend on how much Chinese authorities will let this also go through to company earnings because that is always the question with Chinese companies. We have seen that last year, that the Chinese authorities will not hesitate if they think it’s better to cut some sectors like digital education platforms and I don’t know what they … but I think this growth momentum will be interesting to see.
There’s the chart I created. It shows the European Eurozone and US PMI, manufacturing PMI, so an indicator for future economic growth or momentum and China, and if you see because of these ongoing measures, these lockdowns, how much let’s say PMI growth they lost, if they can only get half of that back, they will be by far the biggest growth contributor globally. And I would suspect this will end up in the performance of emerging market equities relative to developed market equities. Having said that, I got a bit scared the other week because I look at these implied earnings per share growth so how much are investors expecting earnings to grow for the next 12 months. It was negative until I think February. It was negative, negative, negative. It was the only region that was negative. US was positive. [inaudible 00:42:23] was positive. Europe was positive. And now it’s plus 11%.
So investors have priced in this reopening quite aggressively. So this keeps me from going overweight in the portfolios and then considering Europe, so I’m European, Europeans are extremely good in hurting themselves with this energy crisis, with all the restrictions, with the rules. I don’t know why it’s so much fun apparently, but they have a habit of hurting themselves, putting themselves against the wall. And that means that I think that European stocks will structurally or longer term outperform when the global economic cycle turns. And we are not there yet because there is no intrinsic catalyst perhaps for valuation because that is very low or relatively low. But I don’t see the catalysts why European stocks should outperform structurally perhaps or longer term, I must not say structurally but longer term, until this cycle, we get a new cycle. And I think we are going toward the end of the cycle, we don’t have any catalysts helping us. I don’t know why, but that’s the way we work.
If I had to do a word cloud, I love reading your stuff, but one of the words I think I see most often is regression, right? You have some charts, you’re talking about something, but there’s some really fun ones. One of the topics you had in your sort of 2023 outlook, which hopefully we can add parts of to the show notes, listeners, is you were talking a little bit about housing. And I feel like this is starting to feel obvious to some people, and I have a small sample size, but personal takeaways from this like most people do. Talk to us a little bit about your perspective on housing as everyone listening is probably like the majority part of their net worth. How do you see that space today?
Yeah, unfortunately, not that great, I have to be honest. I look at a couple of things, of course. So housing markets depends a lot on prices and mortgage rates, of course. And if you combine those, then it says house prices, home prices I should say, are going down. Only it takes a while. So it’s very slow. And this is also why the year-on-year appreciation of US homes is still higher. So we looked at the relationship between nominal and real, so inflation adjusted home prices and the level of the 30-year fixed mortgage rate. And if I show you yet the chart and I can also, of course, send you an updated version, then you are at levels that mortgage rates are very high. So are home prices still.
So if this relation holds, it’s not a perfect relation, but mortgage rates do explain a lot of home values especially nominal home values. You’re talking about two-thirds so 65% of nominal home prices variation is explained by this 30-year mortgage rates. And then the distance, let’s say, to the historical relationships is quite steep. So if you take that as a starting point, then nominal home prices would have to collapse by 30%. For real home prices, this is much less and that relationship I think makes more sense. So that is one thing and only of course if you think that the 30-year mortgage rate will go down, this whole analysis becomes less downbeat. But the thing is that, while short-term interest rates fell massively, the 10-year yield fell also quite significantly. The 30-year mortgage rates did not fall all that much. So we are still in the same boat of this combination of home prices versus mortgage rates.
And then the second thing that we do I think that’s also pretty straightforward, we can look at the mortgage rates of course, but the second factor that determines the outlook for home prices is how much supply is there on the markets. And you can measure that. There are all kinds of statistics for that. So the months of supply of new one-family home system is one that we use. And if that rises, of course you know what happens because that means when you are trying to sell your house, you are competing with your neighbor who also wants to sell his house before he also thinks prices will go down. And if you update that, and we did that I think a couple of days ago, then you will see that between now and September of this year, home prices would have to fall off around 15% to get that, let’s say, to the traditional regression line or the historical relationship.
There is one thing that can help a bit structurally but most likely not cyclically. That is, of course, that if you look at household formations and if you look at household construction, these are all down the drain. The balance, and that is globally, the balance between housing demand and housing supply is structurally changing in favor of demand. So from a longer term perspective, that doesn’t make that much different for this year of course. But that is a trend to keep in mind on how much impact these mortgage rates and housing supply could have on housing prices, home prices, compared to what they used to do when this supply-demand dynamics were less favorable. So not to be too downbeat on US home prices, that is what I could add. But yeah, I’m pretty sure they will go down quite significantly.
Yeah, it seems like at least here and again, listeners, this is personal experience, but it just seems, a very small sample size, but conversationally sentiment, it seems like at this point it feels like a lot of stuff is just frozen. The transactions are just not happening where people are anchored to valuations and levels from last year and then the buyers are like, “Well, hell, nah.” Something has changed. You’re just not adjusting. So it doesn’t seem like a lot is actually transacting. Saying it differently, the bid-ask spread is wide, so volume seems to have gone down.
And this is a typical phase of what happens. So first you get people don’t want to realize, they don’t want to realize their lower price, they don’t want to agree to it that home prices are going down. But once they start doing it, then you get this rush, “I want to sell now before … Otherwise in a year from now it’s 10% down.” And this is the second lag of this housing market. And this is also, for example, if you look at home builders, they have had a massive rally, but I think when this second phase starts to happen, that it will all come down and that these sectors are not a buy just yet. So yes, I can imagine that a lot of people are anxious to sell their home. Until their neighbor sells it with 2% down, then the next neighbor goes 6% down and you try to sell it for 4% down and then you go. And that is what I think will happen in the coming months.
So we’ve kind of gone around a lot of the globe, asset classes. Is there anything else you can think of that particularly is on your brain as far as overweight, underweight based on your framework that we haven’t talked about? I feel we’ve hit a lot, but is there anything you’re like, “Meb, you haven’t mentioned Dogecoin yet or something else?”
Well, we can always talk about bitcoin. I’m fine with that. Again, I like to be very much in the middle. So no bitcoin maximalist, but not looking at it at all does not make sense either. But I think an interesting asset class that I looked at also recently is high yield bonds. And we have, let’s call it a valuation measure that is called implied recession odds. And what we do, we look at the price behavior of equities, the spread behavior of high yield bonds and investment grade bonds, the price behavior of commodities and the yield curve for treasuries and all of these. And then we looked at the historical, I think the last six or seven US recessions, and we looked at what happened surrounding a US recession, what is the performance of US equities, what is the spread widening of high yield bonds.
And of course the number of observations is not statistically significant, but you have some kind of reference. And then you see even after the recent rally in equities again after the banking crisis, so in October there was 90% implied recession odds given from the performance of US equities because they were down 22% or something. And on averages during a recession or surrounding a recession it’s 27%. So you divide that and so on. Now, what you see stubbornly for months is that global high yield and US high yield, they refused to price in any implied recession odds because historically the spread on high yield bonds always goes towards a thousand basis points. And we are at 400 now. Let’s say at 600 or something, high yield bonds start to price a little bit of recession risk. Now, we did not see that.
So what is different here? First of all, if you look at the interest payments of high yield bonds, they are still extremely low. They have locked in these low rates and it will take a couple of years before they go up. But there’s another thing, and that is why I think the spreads will go up and that is why I’m underweight high yield bonds. If you look at the lending standards, so we have this Federal Reserve Senior Loan Survey. They ask banks how do you look at giving loans to all kinds of companies? Are you more favorable or less favorable? And then you can see the outcome and you see that a lot of banks are tightening these lending standards. And these lending standards are very, very closely correlated with the number of defaults.
Now, obviously in the high yield space, this is where the defaults happen, not in the investment grade space. So these lending standards are already pretty tight. They will go tighter because of the banking crisis, and that means the number of defaults or the percentage of defaults will go up to 5% to 6%. And if you look at history, then the spread should be at this 600, 700, 800 basis point levels. So maybe a not so sexy or interesting asset class but one that I have a clear conviction that spreads are too low for what is about to happen to defaults. So if you own high yield bonds, what we do in the portfolios, we have zero now but we want to be underweight. We want to have less than average, normal, whatever you want to call it.
All right. Well, when they blow out to a thousand basis points, we’ll have you back on and see if your mood has changed.
Yeah, I said so. I said so, yeah.
We’ve talked about a lot today. Is there anything, as we look out to the horizon, so 2023 for the next nine months, anything you’re scratching your head about or marinating on? It’s probably happy hour time there, still coffee morning time here. But as you kind of mull over what’s going on in the world, is there anything in particular that’s on your brain that you’re writing about in future issues or thinking about that the pen to paper is going to hit in the coming days, weeks, months?
So we did some work on the banking crisis, and of course I spent a lot of time looking at the inflation numbers because I think a lot of people do not look at them at the right way, even though they are looking at the same indicator as Powell is. So for me, my guess is that we will get a recession towards the end of the year or the beginning of next year. I was in the beginning of next year camp until this banking crisis occurs. I think that could really get things going a little bit quicker.
But I also expect that central banks, especially now that they have been able to raise rates quite significantly and this is one of the fastest tightening cycles that we have seen since the 1980s, my guess is, and that is to end perhaps with a positive note, is that central banks will be very eager to do what they have been doing since the great financial crisis and even a little bit before. They will cut rates, they will increase their balance sheets. And I think that at that point there will be a very clear entry point for another sustained equity market rally and which we can go on for a couple of years again.
So I’m not of the idea that equities will underperform for a decade, the lost decades, but I think we have to go through this recession. I think where we were in October, this was actually pretty good in terms of numbers and maybe we could in the S&P 500 go to 3000, but we were very close where we would’ve been. And I think now markets have been a little too eager, too excited to go back to these levels already. But once we hit that recession, I think a very solid opportunity will arise to add again to risky asset because I’ve been very cautious for quite some time now. I get a lot of questions, “Jeroen, you’re always negative.” I say, “No, I’m cautious. That’s not negative.” But there will come a time and I think that will be the point, I don’t think there will be a lost decade for equities. Not at all. That then some real return is going to be made.
As you look back over your career, what’s been the most memorable investment? Anything come to mind?
No, I don’t have a favorite investment. I did invest in Amazon stock in, I think, 2009, the timing of that was, but I’m no expert on individual stocks. I did get the idea of Amazon, but I got a couple of, let’s say, where are bond yields going, that right, that also were quite solid. But I must say that since I love diversification, I sometimes have some issues with letting my profits run because I’m so focused on this diversification. But no, I think in general, I’ve been pretty spot on in terms of risk-on and risk-off so that’s nice. And also, since I started the new company, the worst thing that can happen is that your new track record … because [inaudible 00:57:09] was pretty okay, but you cannot take that with you, of course. So the worst thing that can happen is to start off with a really bad track record.
So, in general, I’m happy that the overall positioning between risk-on and risk-off, so risky assets or less risky assets, that has been solid. And also I think the additional performance that created, I’m pretty happy with that. But I too, I’m longing for that period that we can go all in again but I don’t think it’s there yet. I don’t think it’s there yet.
This has been a blast. We’ll definitely have to have you back on. One of my favorite pieces we didn’t talk about today is these markets are never dull, and you had a good one in December where you said the average return doesn’t exist. So as we know, in the future, things will be volatile and all the things we talked about today. There will be no average on these. Things will have moved. Again, we mentioned earlier, but what’s the best place for people to find you?
There you go. Jeroen, it was a blast. Thanks so much for joining us today.
Yeah. Okay. Thank you for having me. It was nice.
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