During strong dollar environments (based on various fiscal and monetary policies), liquid capital flows more towards US equities, whereas during weak dollar environments, it flows elsewhere. This can create a self-perpetuating cycle in one direction or another until a number of catalysts and policy changes lead to a reversal. So, US equity valuations became very high in 2000 (strong dollar period), and then emerging market valuations became very high in 2007 (weak dollar period), and in recent years US equities have once again been highly-valued in a strong-dollar period.

If you expect interest rates to remain near zero for a multi-decade period, then you can infer that fast-growing companies would likely remain extraordinarily highly-priced for a long time. The growth/value forward performance gap would likely narrow, however, because interest rates would likely not keep getting persistently lower (as they’d have to go into negative yields and then keep digging down into lower and lower negative yields to do so). On the other hand, if rates rise to, say, 3% or more, that could put considerable downward pressure on equity valuations, particularly highly-valued stocks with little or no current earnings but large expected forward growth.

Notice that, during the same reduction in the discount rate from 12% to 8%, the growth stock had a notably larger percent increase in its fair value than the value stock (61.8% vs 44.7%). This is because the growth stock has a larger percentage of its expected cumulative cash flows occur far into the future compared to the value stock that is more front-loaded, so a larger portion of the growth stock’s expected cumulative cash flows are subject to the multi-year compounding effect of the discount rate. The growth stock is more rate sensitive, in other words. Whenever we have a big shift to lower interest rates, and the market expects those low rates to persist for a while, then it’s not surprising to see a surge in valuations of growth stocks during that transition from higher to lower rates.

This current period in the 2020s is more difficult for people because despite the fact that stock valuations are so high, bond valuations are so high as well, and investors are stuck between a rock and a hard place. They have to venture into things like value stocks, commodities, or international equities if they want something resembling a historically normal price for things.

The lowest that this version of the equity risk premium ever reached was in 2000, at -4%. That’s why the Dotcom bubble was so silly; you could get a 6.5% yield on a Treasury note, but investors were paying a cyclically-adjusted earnings yield of less than 2.5% for the S&P 500. Then, equities crashed. Treasuries were clearly the better buy there.

Whenever valuations are reasonable, I think investors should consider maintaining some oil and gas exposure, in the form of low-cost producers in diverse jurisdictions, energy transporters with solid balance sheets, and/or long-dated oil futures. Being long uranium holding companies or uranium miners is also a nice diversifier along these lines.

While I do think solar and wind will become a larger percentage of the global electrical grid in an additive way, they’re not very well-suited to actually replace prior energy sources, unless we make some absolutely massive (not merely incremental) breakthroughs in energy storage or turbine/panel longevity. This sets up a decent asymmetric investment opportunity in my view. I think this gap between engineering viability and public/investor perception is providing a long-term opportunity for oil and gas investors, as well as uranium investors. We’re embedding a lot of assumptions into the future energy mix, without necessarily investing in the capex required for that vision, or fully considering some of the technical challenges associated with that vision.

A lot of ESG mandates, current valuations, and capital allocation practices in general, are assuming a rather rapid phase-out of fossil fuels in favor of wind and solar energy. They’re betting on being able to phase out prior energy sources and to reduce the power density of our primary energy sources, for the first time in human history, as though it’s a given. Many of them also appear to be underestimating the technical limitations or true “greenness” of solar and wind power, as it relates to the energy return on investment, recycling issues, reliance on fossil fuels for manufacture, reliance on China to make them cheaply, and so forth.

In a slow-growing country, it’s possible to gradually replace a portion of prior energy sources with new energy sources, at least for the grid. In a fast-growing country, it’s nearly impossible to phase out old energy sources, or even stop growing them.

We find that the lost nuclear electricity production due to the phase-out was replaced primarily by coal-fired production and net electricity imports. The social cost of this shift from nuclear to coal is approximately 12 billion dollars per year. Over 70% of this cost comes from the increased mortality risk associated with exposure to the local air pollution emitted when burning fossil fuels. Even the largest estimates of the reduction in the costs associated with nuclear accident risk and waste disposal due to the phase-out are far smaller than 12 billion dollars.

The companies in the sector don’t get rewarded by investors for reinvesting in growth anymore; they get rewarded by strengthening their balance sheets, being disciplined with drilling, producing free cash flow, and returning a lot of that cash to shareholders.

To summarize the scale of the global ex-USA dollar network, foreigners own $39 trillion in U.S. assets and have $12 trillion in dollar-denominated debts, although the asset-holders and debtors are often not the same regions (e.g. Switzerland is a big asset holder with a surplus, and Turkey is a big debtor with a shortage). Meanwhile, the U.S. is running annual fiscal deficits of well over $1 trillion, and is exporting about $600 billion in dollars annually via its trade deficit, or $3 trillion gross from the U.S. import figures alone.

Based on the numbers, my view is that this third dollar spike likely ends when the Federal Reserve expands its monetary base by trillions of dollars to fund U.S. government deficits over the next several years, for lack of sufficient foreign and private buying of that debt. If performed at sufficient scale, this would loosen the global dollar liquidity shortage.

Imagine, as an extreme example, that the entire world had to use Swiss francs for its international transactions and commodity purchases. It simply wouldn’t work, because there isn’t enough money supply from that small country for the whole world to use. It’s not liquid enough; there aren’t enough francs. The current system is running into that issue, where the United States, as large as it is, is a diminishing share of global GDP, global money supply, and global commodity demand. But, the world is still constrained by dollars, so there are growing pains. The dollar likely does not currently have enough liquidity to serve as the sole global reserve and commodity-pricing currency; there aren’t enough dollars.

The world is now outgrowing the dollar in terms of scale, but still uses the dollar as the global currency. The network effect (and U.S. military force) makes it very hard to shift away to a new system. The United States was 20% of global PPP GDP back in 2000, but only 15% of global PPP GDP today, according to the World Bank. The world’s biggest consumer of commodities during the past decade has been China, not the United States.

In other words, after Argentina and Turkey, the United States is ironically the country that “broke” next in this strong dollar environment, and began monetizing its government debt due to an acute dollar shortage. Fortunately for the United States, it can print its own dollar-denominated liabilities, so its break is less spectacular and more manageable than countries with dollar liabilities that can’t print dollars.

So, rather than sucking existing dollars out of the system as they were from 2015-2019, newly-issued Treasuries are now being funded by newly-created dollars, which means less or no liquidity drain.

In other words, while there is significant foreign demand for dollars (especially to service the aforementioned dollar-denominated debts), there is not a big foreign demand for Treasuries. That’s a key distinction, and that’s what generally happens when the dollar is strong. When the dollar starts rising into a spike, foreigners hold less and less of the debt, as marked in the chart above. This has happened in all three dollar spikes. However, it matters more this time because U.S. federal debt as a percentage of GDP is far larger than it used to be, the U.S. has been more reliant on foreign funding in recent decades.

Foreign central banks mainly accumulate foreign-exchange reserves (i.e. buy Treasury notes and bonds) during weak dollar environments, not strong dollar environments like we’re in now. During a strong dollar environment, they rely on their Treasury reserves to protect their currency and service their dollar-denominated debts if need be. Think of it like a squirrel collecting nuts in the summer to consume during the winter. Squirrels don’t collect nuts in the winter, and foreign central banks don’t buy Treasuries when the dollar is strong and strengthening

The U.S. government increased its debt levels by $4.6 trillion from 2015 through 2019, but foreigners only bought $700 billion of that, and almost all of that was private investors during a brief period in the first 2/3rds of 2019.

While the strong dollar gives U.S. consumers more buying/importing power, it makes U.S. products and services more expensive, and thus less competitive in the export market. Basically, it helps some groups live above their means (and U.S. asset prices have been doing great), but it hollows out the U.S. manufacturing sector and negatively affects the blue collar workforce the most.

Each of these three dollar spikes over the past five decades caused harm to the global financial system at a lower level of dollar strength than the previous spike, resulting in either a planned correction or a self-correction towards a weaker dollar. There are likely two main reasons for this. Firstly, global trade accounted for a larger and larger share of global GDP in each of the three spikes (the first one less than 40%, the second one around 50%, and the third one around 60%, as previously mentioned). Secondly and perhaps more importantly, U.S. and foreign markets have had increasingly high debt-to-GDP ratios over the decades. With more leverage in the system, and with more connectivity between economies, it takes smaller currency fluctuations for something to break.

The reason that the Fed was able to raise interest rates so sharply, and for the dollar to get so strong, was that there was less debt in the global system, and especially in the U.S. system, relative to GDP. The U.S. government and U.S. companies could handle higher interest rates on their debt, because their overall debt levels were low relative to their income levels. In addition, global trade as a percentage of global GDP was less than 40%, compared to 50% a couple decades later, and up to 60% recently. So, in addition to being way less indebted, countries were a significantly less interconnected.

Ironically, the more dollar-denominated debt there is in the world, the more demand there is for dollars, because those borrowers need dollars to service their dollar-denominated debts. That can push up the value of the dollar and further hurt dollar borrowers. It can have short squeeze characteristics, in other words.

The risky part of this system is that many foreign governments and corporations borrow in dollars, even though most of their revenue is in their local currencies. The lender of those dollars is often not even a U.S. institution; foreign lenders often lend to foreign borrowers in dollars. This creates currency risk for the borrower, a mismatch between their revenue currency and their debt currency. They do this because the borrower can get lower interest rates by borrowing in dollars rather than their local currency, thus taking on currency risk themselves instead of the lender taking on that risk. Sometimes, dollar-denominated bonds and loans are the only option for them. By doing this, the borrower is basically shorting the dollar, whether they want to or not. If the dollar strengthens, they get hurt, because their debts rise relative to their local-currency income. If the dollar weakens, they get a partial debt jubilee, because their debts fall relative to their local-currency income.

Is there any particular reason why investors’ money should be 3x more concentrated in Japan than Canada? Or 6x more concentrated in Japan than South Korea?  Or 11x more concentrated in Japan than Brazil? Just because Japan’s stock market is the biggest There’s no compelling reason for international stock funds to be weighted strictly by the stock market size each country. It makes far more sense to broaden and diversify more evenly, so that you’re not so heavily tied to the fate of just one country. Especially a shrinking country.

Many companies charge far higher prices for drugs in the United States than they charge elsewhere, because we lack the same level of price negotiation as many other countries have.  In this sense, we subsidize other countries.

There are over 44 million Americans with student loans, and the average per-student debt at graduation among students that have loans is over $35,000. And although it dis-proportionally affects people under 40, approximately one third of total student debt is held by people over 40 years of age. Plus, parents are often co-signers for the loans of their children, which exposes them to the risks.

Bonds and stocks do well in goldilocks periods of strong real growth, with low inflation and high productivity gains. Between the two, stocks can do better. Commodities and gold are prone to poor performance in this type of environment.

If temporary deflation is caused by a deflationary shock, such as a recession or depression, bonds are the place to be, and outperform everything else. Gold also generally does fine compared to other assets. Stocks and commodities usually perform very poorly.

During periods of moderate to high inflation, gold and commodities tend to do extremely well. Equities outperform bonds more often than not, but it depends on the type of equities and their starting valuations, and therefore have a huge variance. Real estate does well, mainly because leverage attached to it gets melted away from inflation. Bonds do poorly in inflationary environments.

When interest rates rise, it puts downward pressure on most asset prices, as we saw in the inflationary decade of the 1970s. When interest rates remain low, then monetary inflation remains a decent environment for asset prices, as we saw in the inflationary decade of the 1940s from the market bottom in 1942.

Monetary inflation, meaning a rapid increase in the broad money supply, is driven either by an increase in bank lending or large fiscal deficits.

However, if you bought a Treasury note leading up to any of the three major inflationary periods in this 150-year history and held until maturity, you lost purchasing power at up to a -5% annualized compounded rate for a decade, which led to approximately a -40% loss in purchasing power by the end. In other words, Treasury buyers in those periods basically made giant donations to Uncle Sam.

More specifically, the top 1% of households in the United States have $39.4 trillion in assets and less than $0.8 trillion in debts, which gives them a net worth of $38.6 trillion. So, they have a debt/equity ratio of just 2%. Almost their their entire balance sheet consists of assets. Meanwhile, the bottom 50% of households have $7.6 trillion in assets and $5.1 trillion in debts, resulting in just $2.5 trillion in net worth. So, they have a debt/equity ratio of 200%. Their balance sheets have a lot of debt relative to equity, and almost as much in debt as in assets.

This is something to keep in mind when you are told that inflation is transitory. It’s often transitory in rate of change terms, but not absolute terms. With inflation that is transitory in rate of change terms but not absolute terms, broad prices stop accelerating to the upside, but don’t come back down.

The top 10% have increased their share from 60% of the wealth to 70% of the wealth. The top 1% alone hold slightly more household wealth than the bottom 90% combined. So naturally, most people don’t feel like price inflation is as low as CPI says it was. Their actual ability to buy a good living doesn’t match with what it says.

One of the biggest price growth outliers was tuition, with a 4x (300%) increase compared to 2x (100%) for the broad CPI from 1990 to 2020. Decades ago, a 4-year or 6-year college education wasn’t necessary to have strong wages. Right out of high school, young adults could start earning money without student debt assigned to them. More prestigious careers of course generally needed the higher degrees. But due to globalization, offshoring, automation, and reduced union participation, there has been considerable downward wage pressure on many types of non-college jobs. The median male income has been virtually flat in inflation-adjusted terms over the past four decades, but he increasingly needs a college degree and student debt in order to earn that median income. And the cost of that degree has gone up at twice the pace of broad CPI.

So, if the majority of things that Americans spend money on went up faster than broad CPI, it brings into question the accuracy of broad CPI. That basket of housing, education, food, healthcare, and transportation represents 60% of total average household spending according to the BLS, or about 70% of total ex-pension and ex-charity spending.

Based on this funny but actually kind of relevant metric, CPI has fallen short over the past three decades, and particularly within the second half of that period. Back in the late 1990s and early 2000s, commodities were very cheap, and so the Big Mac rose in price more slowly than CPI. Starting in 2003, commodity prices had a big rise up, and Big Mac prices caught back up to CPI and eventually outpaced it by a noticeable margin.

Certainly we can allow for a substantial amount of quality adjustment in the new car CPI calculation. The new Camry has power everything, a navigation system, better safety features, and better gas mileage. But is the quality/size adjustment enough to reduce the actual price appreciation from 100% down to just 22% on a quality-adjusted basis during this three-decade period, as official new car CPI says was the case?

The new Camry has power everything, a navigation system, better safety features, and better gas mileage.

Certainly we can allow for a substantial amount of quality adjustment in the new car CPI calculation.

I dug up an old Chicago Tribune article that had some data to cross-reference that. According to that article, the average price of a new car in 1990 was $15,472. In 2020, the average price of a new car crossed over $40,000. That’s more than a 2.5x or 150%+ increase in price, during which the new vehicle CPI says that it effectively rose only 22%.