In a TSI commentary last November I wrote about adjustments I was making to my stock selection process. These adjustments weren’t due to issues with any individual stock(s) or the performance of any individual stock-market sector. In particular, the poor performance of the average junior gold-mining stock during 2019′s gold rally wasn’t the primary driver of my decision to make some changes, although it was the proverbial “last straw”. The primary basis for my adjustment was evidence that the investing landscape had changed in a permanent, or at least a semi-permanent, way.
Long-term changes in the investing landscape happen from time to time, that is, the future is not always a simple extrapolation of the past. This occurs not because of a change in human nature (human nature never changes), but because of a change in the monetary system. For example, the investment strategy that involved shifting from equities to bonds when the stock market’s average dividend yield dropped below the average yield on investment-grade bonds worked without fail for generations prior to the mid-1950s, but from the mid-1950s onward it didn’t work. The reason this ‘fail safe’ approach to asset allocation stopped working was the increasing propensity/ability of central banks to inflate the money supply.
As part of their attempts to encourage more borrowing and consumption, over the past few years the major central banks manipulated interest rates down to unprecedented levels. Ten years ago very few people thought that negative nominal interest rates were possible, but in 2019 we reached the point where 1) a substantial portion of the developed-world’s government debt was trading with a negative yield to maturity, 2) some corporate bonds had negative yields to maturity, and 3) banks in some European countries were offering mortgages with negative interest rates.
Due to the draconian efforts of central banks to promote more spending and borrowing, it’s possible that the public is now effectively ‘tapped out’. This would explain why the quantity of margin debt collapsed over the past 18 months relative to the size of the US stock market, something that NEVER happened before with the S&P500 in a long-term bullish trend and regularly making new all-time highs. Also, it would explain why the average small-cap stock (as represented by the Russell2000) is trading at a 16-year low relative to the average large-cap stock (as represented by the S&P500).
Linked to the relatively poor performance of the average small-cap stock is the increasing popularity of passive investing via indexes and ETFs. Over the past several years there has been a general decline in the amount of active, value-oriented stock selection and a general rise in the use of ETFs. This has caused the stocks that are significant components of popular ETFs to outperform the stocks that are not subject to meaningful ETF-related demand, regardless of relative value. There is no reason to expect this trend to end anytime soon. On the contrary, the general shift away from individual stock selection and towards the use of ETFs appears to be accelerating.
At this stage I’m not making dramatic changes to my stock selection approach. I will continue to follow speculative small-cap stocks, but my selection process will be more risk averse and I will reduce the potential tracking error during intermediate-term rallies in mining stocks by putting more emphasis on ETFs and mutual funds. Also, when making future speculative mining-stock selections I will pay greater heed to the attractiveness of the assets to large mining companies. The reason is that regardless of the public’s willingness to speculate, large mining companies will always be under pressure to replace their depleted reserves and add new reserves. The easiest way for large companies to do this is to buy small companies that have discovered mineral deposits of sufficient size and quality.
In summary, as a result of unprecedented manipulation of money and interest rates it’s possible that some of the investing/speculating strategies that worked reliably in the past will not work for the foreseeable future. I think it makes sense to adapt accordingly.
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