Q3 Update - Adjustments to tariffs and the inflating bubble
Reviewing our previous insight post in late March, we had a bearish outlook and felt the market was overheated. We highlighted the various risks associated with deploying into equities from late March, and to a certain extent, that turned true when Liberation Day led to the S&P 500 and NASDAQ dropping almost 15% within 3 days. But following that was a tremendous, continuous rally, led primarily by the magnificent 7. The broader markets recovered within a few months to pre-liberation day levels and then broke through to all-time highs to this day. During this period, we have participated in the upside through selective equity picks, notably a prominent position in Reddit Inc., and have been averaging our long-duration bonds (10-20 years) in anticipation of continuous rate cuts.
But when we dive into valuations, it tells a very precarious story, and we have a fundamental basis to believe the market may be getting way ahead of itself. This is the third time the market has touched a Shiller P/E ratio of 40, the other two were in 2000 and 2008. While history does not repeat, we believe it sure does rhyme.
Furthermore, we feel it in the outlook and sentiment of the marketplace. Every discussion topic seems to be now dominated by AI, spanning corporate strategy, fundraising, investment, economics, and even casual social settings. This translates to stock price movements. Any AI-related stocks can surge 20-30% on a random Tuesday due to rumors or speculation of a deal, and this is after months of the stock multiplying 2- 3x its value. Many of these AI names have essentially no revenue and trade based on “projected deals”. These are names like OKLO, SMR, QBTS, and IONQ. This is as clear a sign as any that we are near or at euphoria.
What tipped me to be cautious of the current state of AI are two recent observations. 1) These AI agent and chatbot providers are far from profitable, and 95% of companies that invest in AI do not see any tangible ROI 2) News that these players have begun scratching each other’s back (such as the $100B NVDA-OpenAI and the Oracle-OpenAI RPO deal). While I am a proponent of AI and its benefits in the long run, we as humans always overestimate in the short run. It is part and parcel of our human condition, and it's NOT different this time around.
Valuations don’t matter until they do; thus, we are selling off most of our high-growth equity positions and trimming our highest conviction picks (one of which is Reddit) while looking to remain in long-duration treasuries, precious metals, and stalwart companies. Our primary concern at this point is the weakening of the U.S. consumer, which is often drowned out by the more exciting AI chatter. Companies have begun using AI as grounds to lay off excess staff and seek more cost-effective solutions to improve profitability. Concurrently, the federal government has cut wasteful fiscal spending and incentives. These material threats to the labor market have begun to make cracks in the labor reports and will eventually lead to reduced consumption; we will continue to monitor this trend closely.
We still believe gold and especially silver have more upside potential heading into next year; thus, we have not begun trimming our positions. Investors are primarily focused on U.S. monetary policy for the projection of these precious metals, but keep in mind that the rest of the world has already begun cutting interest rates and expanding money supply in the face of economic headwinds. The data indicate tariffs have hit exporters and producers (mainly in China/Korea/SEA) hard, as they are the ones primarily footing the bill. U.S. CPI has stabilized while PPI continues to drop. Investors abroad have been piling into these metals not just because of uncertainty, but also to protect themselves agaisnt the risk of the destabilization of their own domestic fiat currency.
The short USD seems to be the most crowded trade this year, but in recent months, the charts show evidence of a floor. The weakening trend could reverse, and the USD could strengthen if the rest of the world experiences a decelerating growth. The risk-free rate in the U.S. remains elevated and above most of the developed world. As long as investors can be comforted by the rising concerns related to sovereign debt, this should lead to a sustained growth in the appetite for U.S. treasuries/USD.
Additionally, if we assume that supply (exporters to the U.S.) is relatively inelastic, the implementation of import tariffs shouldn’t impact the USD significantly. On a medium-term horizon, the incentives and coercion to direct hundreds of billions of foreign capital into the U.S. should bring about an uplifting force. Therefore, piling on to that thesis of reducing exposure to the USD at this point would not be advisable.
We believe the potential for value destruction and financial loss could be comparable to the dot-com boom. Nobody knows when, and shorting would not be wise, but it’s a question of when, not if. We will also sell covered calls on our equities when the price of volatility is appetizing.
How to position forward
1) Gold/Silver ETF (GLD/SLV)
2) Long-duration US bond ETFs (TLT/IEF)
3) Consumer Staples, Utilities, Tobacco (ETR, D, MO, SRE, PM)
4) High conviction equities (RDDT, CHA)
