Strange times call for strange asset allocations, according to DoubleLine Capital CEO Jeffrey Gundlach.

The U.S. is in a "strange recession, and to deal with an environment that could switch from disinflationary to inflationary overnight, it’s best to dispense with asset allocations built from Modern Portfolio Theory and try something different, Gundlach told advisors during a breakout session at Schwab’s 2020 IMPACT conference yesterday .

Gundlach recommended a portfolio divided into quarters divided among cash in case deflation happens, gold in case of inflation, long-term Treasury bonds as a deflationary asset and stocks, which he said are “helpful” in inflationary situations.

“The point behind 25%-25%-25%-25% is to show how unusual the situation is,” said Gundlach. “If we have deflationary liquidation, Treasury bond yields will go to a very low level, close to zero, and we’ll see a big gain in 30-year Treasuries—but I expect a loss in that area of the portfolio. A diversified portfolio always has something that isn’t working.”

Bond investors should still be careful, said Gundlach, because foreign buyers of U.S. Treasurys have gradually exited the market over the past three years, and because current yields appear to be too low based on several long- and short-term indicators, like the ratios of copper to gold and defensive to cyclical stocks, hourly earnings, and year-over-year  changes in nominal GDP.

Gundlach titled his session “Hey Kid – Want Some Candy?” as a metaphor for massive intervention in financial markets by central banks, legislators and other policymakers.

“We teach children not to take candy from strangers because, first of all, candy is not very nutritious,” said Gundlach. “Second, you don’t want the danger of bad outcomes that are associated with strangers. What the government has done is distribute an awful lot of candy, and it’s had the effect of a sugar high in the economy for sure.”

Part of Gundlach’s “candy” is a long-term zero interest rate policy and massive security purchases by the Federal Reserve. Bond investors should take heart that there’s very little appetite for negative interest rates among policymakers, including Federal Reserve Chairman Jay Powell, he said.

While Gundlach decried rising deficits caused by fiscal stimulus and the expansion of the Fed’s balance sheet, he said they were preferable to negative interest rates. Stock markets in Europe and Japan have never recovered from the impact of negative interest rates, he said, and the U.S. has become the last haven for the world’s savers. Going to negative interest rates would leave these savers with nowhere to go, said Gundlach.

“If we do, we will see a collapse of the global financial system,” he said. “You can’t have that kind of capital destruction.”

The Fed’s bond buying moved into the corporate bond space during the Covid-19 crisis, Gundlach notes, in violation of its own charter. This “candy” in the market has led to corporate bonds in general being significantly overvalued.

Currently, corporate borrowers are leveraged “at levels never seen before,” he said.

“The question will be: Is there going to be solvency in the corporate bond market?” he asked. “You can’t, by targeting prices, improve solvency. I think that large bankruptcies are going to blow away the records of the past two recessions.”

On the other hand, fiscal stimulus in the form of the CARES Act put money into the hands of unsophisticated retail investors—offering another form of sugar high, said Gundlach.

“The Fed is spreading candy to children, and the children are gorging themselves on little slices of stocks,” said Gundlach. “It’s systematic of a top, and it does not end well.”

Retail investors are also partially to blame for overvaluation in corporate bonds, he said, adding that retail investing booms should be seen as contrarian indicators.

Fixed-income investors may still find opportunities in loans, CLOs and mortgages, said Gundlach—particularly in agency mortgages, where risk may currently be mispriced in comparison to corporate bonds.

“Commercial mortgages are viewed to be dangerous, especially in certain industries,” he added. “What does that mean? Opportunity. ... You want to invest in things that are not protected by the Fed. They’re at a value.”

Gold may be the only “safe” asset in 2021, said Gundlach, who also recommended industrial commodities for those able to access them.

Gundlach warned against owning U.S. stocks.

“If you own U.S. stocks, you’re playing a momentum game that is dangerous broadly,” he said, noting that most of the returns of the S&P 500 since the coronavirus pandemic took hold have been generated by six technology stocks. “If you want to own U.S. stocks, you’re betting on more big tech momentum, which means you should be buying big tech if you’re bullish on U.S. stocks.”

U.S. stocks are overvalued due in part to a massive entrance of retail investors into the market over the last seven months, said Gundlach, and the only way to justify buying them is if one has an inflationary outlook, which he said makes little sense. Earnings for 2020 have thus far come in line with their 2017 levels, but the market is “substantially” higher, he said.

Gundlach says that it’s unlikely earnings will be sufficient to justify high prices for U.S. stocks, which is why he argues investors should look to the rest of the world, especially emerging markets, for the equity portions of their portfolios.

Adding to the likelihood that international stocks will outperform U.S. stocks is Gundlach’s outlook for the U.S. dollar. As budget and trade deficits rise, the long-term value of the U.S. dollar should decline, he said.

Gundlach called the decline of the U.S. dollar in coming years his “highest conviction idea.”

“The guess is that the U.S. is going to be weaker than the rest of the world ex-U.S.for 2020 and 2021,” he said.

Currently, an average forecast for 2020 U.S. GDP is for negative 4% growth, compared to an average forecast of global GDP ex-U.S. at negative 3.9%. For 2021, U.S. GDP is expected to grow by 3.7%, compared to 5.2% for global GDP excluding the U.S., said Gundlach.

“Twenty-four percent of small businesses are closed due to Covid,” he said. “Is that permanent? No, but I think that number is going to accelerate again.”

Fiscal stimulus was handled “hamfistedly,” explained Gundlach, leaving most small business owners “hanging by their fingernails to the side of the cliff” while larger companies and larger borrowers have benefitted.

Gundlach also said that, after being bullish on bitcoin earlier in the year, today he feels that the cryptocurrency is nothing more than a speculation tool that might not survive.

He also stated on Tuesday his conviction that President Donald Trump would win re-election, and that the Senate would remain in Republican hands. In contrast, AGF Investments Chief U.S. Policy Strategist Greg Valliere predicted a Joe Biden win during the conference.