With regards to stocks, we don’t have a crystal ball, but are concerned about high valuations. Without giving a specific investment recommendation, we would not be surprised if small caps (as expressed in the Russell 2000) outperform large caps (as expressed in the Nasdaq). The reasons include:
• Just as larger firms tend to relatively benefit from more regulation as they have more economies of scale, a reduction in regulation may well benefit smaller firms disproportionally.
• The Nasdaq companies tend to be more internationally active and, as such, be more vulnerable to retaliation on any policies by other governments.
• Historically, in the stock market declines we have studied, the Russell 2000 has outperformed the Nasdaq. The reason may be that the Nasdaq has the more popular (and thus pricier) firms. While I believe this may well apply, a caution to this theory: in 2016, the Russell outperformed the Nasdaq already.
To protect against a general decline in stocks, one may need to look further. In that context, cash is an option that is often not mentioned. As investors ponder ways to diversify - or even just a rebalancing of portfolios as equities have outperformed other asset classes - keep in mind that equities tend to be more volatile than some alternatives; as such, to be protected in a downturn, one might need to load up quite substantially on alternatives. As an extreme example: to protect a 100% stock portfolio against a broad market downturn, it would really need to go to almost 100% cash if one wanted to avoid the risk of losing any money. As most investors don’t want to do that, investors are looking for diversification, i.e. for investments that have a low correlation. To the extent that one finds such investments, a similar test should be performed though: how much does one need to add to attain the desired diversification?
Bonds should prove interesting in 2017. My personal opinion is that we saw historic lows in 2016. However, if stocks were to tumble, wouldn’t bonds rally? Possibly. What I’m concerned about is that bonds will fall for different reasons than in 2016: in late 2016, more real growth was priced in; I happen to believe that some of those higher real growth expectations will be replaced with higher inflation expectations.
If that happens, bonds can lose money even if stocks fall. More so, the dollar might not be so shiny after all, if higher inflation is priced in. Fed Chair Yellen recently (at Stanford on January 19) gave a speech in which I interpreted her argument as to suggesting "this time is different" as rising inflationary pressures e.g. in wages are really not as strong as some say.
That’s not to say other currencies can’t suffer in a trade war - the Mexican Peso has been particularly vulnerable as the Mexican economy is particularly dependent on exports to the U.S.; China’s currency may also be vulnerable as speculators could increase their attack on the currency should China be pushed into a corner. That said, I am more optimistic on how major currencies will perform versus the greenback, as we may have seen the low in interest rates in much of the world. Last week, European Central Bank President Draghi fought against that perception, but it was a fight in words only which I characterized as "huffing and puffing" to pressure the currency lower - a strategy that worked for a few hours that day.
What about gold? As we have indicated in the past, gold may be the "easiest" diversifier. Easy because it’s easier to understand than other investments that might be able to perform well when both stocks and bonds are vulnerable (e.g. a long/short equity or long/short currency strategy). We believe gold is a good diversifier over the medium to long-term, as its long-term correlation to equities, in our analysis, is near zero; that said, the price of gold can have an elevated correlation to either stocks or bonds over shorter periods. If I am right that inflationary pressures will increase, then gold may benefit. If, however, Trump’s policies will foremost boost real growth, gold might suffer. One reason why I am optimistic on gold is that I haven’t seen any proposal to get long term entitlement spending under control which is, in my view, key to long-term fiscal sustainability. The link to gold is that a lack of long-term fiscal sustainability may lead to negative long-term real rates which, in turn, would be a positive for gold which has a cost of holding and doesn’t pay interest.
Axel Merk is president and chief investment officer of Merk Investments.