MAGGIE LAKE: Hello, and welcome to the Real Vision Daily Briefing. It's Monday, January 3rd, 2022, the first trading day of the new year. Still sounds a little weird to say that. I'm Maggie Lake, here with Alfonso Peccatiello, author of The Macro Compass. Hi, Alf. Happy New Year.
ALFONSO PECCATIELLO: Hey, Maggie, Happy New Year and Happy New Year to everybody listening to the Real Vision Daily Briefing.
MAGGIE LAKE: Yeah, I hope it's going to be a prosperous month for everyone, we're certainly going to try to help out on that front. Before we dive in, and there's so much to talk about, before we dive in, just to a quick snapshot of what the day look like. UK, China, Japan all close today, but the US was open for a full session, first full session. And once again, big tech in focus.
The NASDAQ was the best performer of the major US equity indices. Apple became the first company to hit a trillion dollar market cap. Tesla up 13% on record delivery, some of those old familiar names were leading once again. In bonds, US Treasurys sitting at 1.63%. Oil continued its rally edging up a little bit about 1%, and Bitcoin and Ethereum lower, both lower once again.
Alf, there's been so much talk about maybe that 2022 is going to be volatile, or it's going to be harder, and there's going to be a lot of chops to get through. What's top of mind for you as we kick off this new month, new year?
ALFONSO PECCATIELLO: Well, the first trading session is pretty telling, I would say. There's a lot going on for a first trading session. As you said, bond yields are 12 basis points higher and you have equity markets moving already, you have crypto taking a little bit of a beating. Gold as well, by the way, is down on the day pretty remarkably. One thing I would say immediately is that we have seen, I don't know, a gazillion forecasts for 2022.
And a few days ago, I posted something on Twitter that went pretty viral, which was basically a scatter chart, it's chart number three in our deck that basically shows-- also for people listening to it or not rather watching it, how Wall Street forecasts of the S&P price at the end of next year are absolutely explaining basically 0% of what the subsequent 12-month return of the S&P will be. Literally, there is no correlation between these highly paid Wall Street analysts are going to forecast for the S&P and what the S&P is going to deliver at the end of next year.
If they're giving it a try, we can give it a try too, but the one-year ahead forecasts don't seem to bring too much information value. We have to take this day by day, month by month and the macro landscape always changes. The other thing I would like to say before we go into what's likely to happen this year, what are the best risk reward trades out there in macro land is that one of the most important things at the end of the day is to be invested in a smart way. That's what we are all trying to do.
And there was an interesting study from JPMorgan, they actually update that I think every year where they take some data from a dowel bar, where they look at basically the average investor behavior, that's in chart number two. The orange stack, which is the average investor over the last 20 years has been able to achieve about 3% nominal returns and inflation has been about 2%. Just a meager performance, they've just managed to keep their purchasing power intact, effectively just beating inflation by a tiny bit.
But look at the simple 60/40 portfolio, that delivered 6.5% nominal returns each year. And the S&P, 7.5%. Obviously, there are levels of volatility and drawdown appetites out there for every investor. But ultimately, being invested in risk assets is important over the long term. And doing it in a smart way is what we're trying to do.
MAGGIE LAKE: Yeah, I think that's so important. And a couple of points you mentioned are so important. First of all, for those who are maybe listening and can't see, the chart showing the forecast, this is what all over the map. I think that's where they say game from, because it's true, they really are. And I think that creates a lot of anxiety when you're trying to figure out what to do.
Why is it so hard for the individual investor to come out on top? What is the mistake do you think that results in that JPMorgan study showing that you're barely making it above inflation? Do people trade too much? Do they put too much faith in one asset class? What do you think drives that?
ALFONSO PECCATIELLO: Couple of common mistakes I would say. While there is an underlying problem, which Real Vision, for instance, is trying to solve, democratizing financial knowledge, which is financial literacy, literally. Take Italy as an example, if you ended up out of high school or university in Italy, Maggie, you know very, very little about basic economic theory, let alone how to manage your savings. Financial literacy is not great all over the world and I think we can do something at the policy level to make that better.
And then there are a couple of recency bias or behavioral mistakes from investors. I recently posted something about mean reversion, which yes, of course can work and does work in certain strategies, but people tend to think that what has outperformed against something else must come down, for example, or must mean revert to something, because it's a little bit like we are hardwired as human being to look at a mean and then a distribution and say, okay, this must revert back to the mean, or, for instance, taking way too many risks than your drawdown appetite really easy in your portfolio.
Because beforehand, you make a very loose assessment if you make one at all. What kind of volatility and drawdowns can you really stomach in your portfolio? And then you end up allocating way too much to risk assets. And when the drawdown happens, you tend to do the most suboptimal choice, which is to sell at that very moment.
And then the third one is that people, I think, just misunderstand the nature of risk assets. I always try to describe being invested in the stock market for the long term as effectively being invested to the growth of the world out there. If earnings are growing, that's the first very strong tailwind to stock market or the returns, so not being invested into the stock market basically means that over the very long term, decades to come, you expect earnings not to grow.
Of course, the starting point and valuations are important, but there are a couple of behavioral assessment that are not, I think, right out there, and we'll try to bring out there this financial knowledge democratization process a little bit more.
MAGGIE LAKE: Alf, I think that's so wonderful, because I'm raising my hand because I have felt all those things you just described. And I think having that top of mind for all of us, as we try to make decisions is super helpful. Just going back and checking against that, am I falling into the same pattern, and making the same mistakes over and over again, because we tend to. That's a super helpful way to think about it.
It's nice to know that I'm not the only one making some of those mistakes or falling into those habits. When you're looking at, let me ask you about that mean reversion idea that something that move must revert back to the mean, how are you thinking about that against the context of the S&P 500? Especially when we look at some of the stocks moving again, today, Tesla, it's a stock that people love to love or love to hate, and some people are convinced it's going to come down.
And then other people have a different mindset about it, and maybe don't realize how much risk. I feel like it could fall in both those buckets. How do you think about the S&P 500 and a stock like Tesla against what you just described?
ALFONSO PECCATIELLO: Yeah, that's a very good question. If I take the S&P 500, obviously, it has outperformed any other major stock index, and let's say jurisdiction. If I take the S&P against the Emerging Market Index, which is China heavy, but even if you exclude China from the Emerging Market Index, you will find that over the last 12 years, it has relentlessly outperformed.
At some point, people expect this to revert and emerging markets and value stocks and small caps and all the beaten up stuff to actually catch up to the S&P 500. Well, this might be true, but at the end of the day, what I want to pass as a message is that your assessment over a risk reward trade should not be biased by what your bias really is. If your bias is to think that things must mean revert, then obviously, you will think at some point, yields have to go up, emerging markets have to outperform, and value stocks have to outperform.
And then of course, also Tesla and Apple have to mean revert to more decent valuations. When we talk about these stocks, what you're really talking about is valuations, because especially for Tesla, if it's true that earnings are going up and these guys are delivering a little bit more on the core of their business than they were delivering in the past, the heavy lifting in the Tesla total return is definitely coming from valuations.
And this valuation heavy part in the stock market is one of the most difficult to comprehend for average investors that over the last 40 years or during their investment lifetime, are not used to see something trading at 30 times sales, for example. That seems really unbelievable and unsustainable. And, of course, I'm not here to say that these valuations are sustainable or likely to stay there forever, but I'm here to try and rationalize why some of these valuations are that high.
There must be a reason why they are that high. And the average explanation out there is that basically, your risk free real interest rate is negative and is very, very likely to remain negative. Then if you have an asset class that will grow with secular trends, which is this tech heavy asset class, let's say, and we'll be able to deliver cash flows, robust cash flows over the long term, then these cash flows are very, very valuable in a world where the alternative, which is the risk free real interest rate, is actually negative.
When you discount these cash flows that are here to stay in secular trends for a very long time with a discounting factor that is extremely low, which is basically your risk free real interest rate, you end up at higher valuations. That's what the theory says. Now, are they way too high, or are they high? That's another, let's say, assessment. But the message is, let's try to rationalize this process.
MAGGIE LAKE: Sure. And it makes sense, because you can think the world should be a certain way, but you have to operate in the one that you're in. And that's, I think, what you're talking about when you're talking about the reality of what you have to trade at this given moment, you've got to plug into that even if you in your gut think that it shouldn't be that high.
You mentioned before the value stocks, this rotation into value stocks, and I was thinking about that, too, because back to all of those forecasts, the official forecasts and strategies that are talking so many of them, I think there was a poll I saw somewhere, so many of them are saying this will be the year, this will be the year that value finally takes over and technology is going to take a backseat.
Are you buying that? Let's talk about what you're-- we'll talk about what you don't like a little bit later, we'll tease that, but what do you overweight? What do you like right now in this environment? Are you overweight value?
ALFONSO PECCATIELLO: Now, I am trying to make predictions. Wall Street analysts, zero correlation between their predictions and S&P returns, let's Alf's predictions against the S&P returns, or whatever the market returns will be. In chart number one, this is basically the last piece I published at The Macro Compass. At the end of the piece, there was a table where I told my readers what I was leaning overweight and underweight against what I call the model ETF portfolio, which is again, just a benchmark portfolio I'm trying to use to lean overweight or underweight different asset classes.
To answer Maggie's question, no, I am not long the cyclical stuff here. If you see the orange box, this basically mean a little bit underweight and you will find in there I'm underweight in the Russell, I'm underweight in China, I'm underweight in Brazil equities, for example. I'm underweight in Bitcoin, I'm underweight in gold, and I'm underweight in TIPS, so inflation breakevens. And the overweight in there is in dollar cash, short term cash, and in, let's say, a bunch of growth stocks and low beta stocks, so what we discussed with Darius Dale several times as well in the past.
Of course, here, I'm simplifying in this table to make sure that people can understand what I'm leaning long and short. It's a bit more complicated and detailed than that, but if you really have to be invested in the stock market right now, my suggestion would be, or what I would do would be to be long low beta stuff and belong to certain sectors of the tech market like Apple, for example.
This high quality, cash flow delivering tech part, and not the highly cyclical part like emerging markets. I used China and Brazil in this example, or value or cyclical stocks like the Russell. And also, this is not the time to be long Bitcoin to be really honest, or gold or TIPS for a very similar reason. New money is not flowing into crypto at the same pace as before. And there is a reason for that, the credit stimulus has stopped compared to last year.
And as you expect, the Federal Reserve and other central banks to embark in a tightening cycle, your risk free alternatives of short term cash will actually start to yield in an incremental way slightly better than it did until last year. The incremental flows are not there, not supporting for these asset classes like gold or Bitcoin which are not underpinned by cash flows effectively, and the alternative to disaster classes.
Dollar cash, for instance, or something very short term and risk free starts to be on a relative basis, a little bit more appealing. And the same for TIPS, which are basically the reverse of real interest rates, which I expect them to go gently up as the Federal Reserve tries to go on a hiking cycle.
MAGGIE LAKE: There's so much to dig in, and we've got some questions as well, but I want to bring a clip from another conversation in too because I think it will tie into what we're talking about. And you mentioned Darius Dale. Darius spoke with Cem Karsan about inflation and the relationship it has or the impact it has on the stock market. Let's have a listen to that.
CEM KARSAN: It's a matter of time. And we've all seen the cycle play out, and my point is we haven't seen inflation since 1979. And you think about the effects that that's had and how ingrained that type of period, we're talking two generations. The majority of the investment landscape, the firms that have succeeded on the back of buy and hold, on the back of passive investment, on the back of risk parity, on the back of all these things that aren't going to work anymore. That's where all the assets are.
And that's the mentality of your average investor. I talk to investors every day, and the concept of non-correlated investment, active management are dead because it hasn't worked. It's too expensive in the market that goes straight up, or as long as you close your eyes, it comes back very quickly, because you know the Fed's going to step in and do monetary policy. Now, their reaction function has changed and more importantly, the government's reaction function has changed.
And I'd argue over again, next [?] on the market, you're likely to get more fiscal stimulus, whether it's left or right. And the housing policy is going to be we're going to get some stimulus next time the market pulls down in that respect. I think that's one way we're going to get a lot of fiscal particularly for these millennials and groups that have really low homeownership. These types of things are going to be part of the popular programs that people have experienced that. And that completely creates a different environment for stocks.
MAGGIE LAKE: And that full interview is available on Essential Plus and Pro tiers. Alf, we're going to get some minutes from the Federal Reserve this week, I believe they're released on Wednesday, what are you expecting when it comes to the Fed? And what are we seeing in the bond market? I think this has people confused.
ALFONSO PECCATIELLO: Yeah. Today, the bond market move is, in standard deviation terms, relatively large for a single day. You have bond yields about 10 basis point higher across the curve, with the long end of the curve actually moving even a bit more than the short end of the curve. Actually, I think we first need to break down for a second this bond market move. Bond yields can be approximated as the sum of real yields and inflation expectations. And today, what has moved is the real yields part.
Real yields have gone up, bond yields have gone up, but inflation expectation haven't actually moved much. It's all about real yields today. When real yields go up, Maggie, what I normally say is as long as the economy's healing, and there is a cyclical pattern of GDP growth and earnings coming true, and the labor market is healing, then real interest rates can afford to go slightly up.
When that is not the case, then a move higher in real interest rates actually causes some distress in risk assets. Today, risk assets have reacted pretty well and there is a reason for it. Real interest rates are, in my opinion, able to go up this year without causing too much distress in risk assets. Because the labor market is healing, the labor market is very hot. We have some tailwind left into the cyclical GDP recovery out there.
And another important thing is that real interest rates start from very, very depressed levels. Five-year real interest rates in America are like negative 2.5% or so. Of course, there is some gentle way up that the Federal Reserve is trying to engineer this asset class towards policy normalization, towards what I call equilibrium levels. A move like we saw today, obviously, if you repeat that for a week in a row, 10 basis point higher every day, then at some point, it becomes too much.
The pace of this move is