24 Feb

Another tailwind for pink diamonds

Market attention this week seems to be almost completely focused on geopolitics, with the tensions between Russia and the Ukraine front of mind.

The potential for things to deteriorate into an actual shooting war is an obvious risk, though let’s hope it doesn’t come to that, given the human tragedy that would inevitably follow.

Geopolitics aside, the need for investors to both assess the risks in traditional assets and look for alternative opportunities to protect and grow wealth was reinforced by some market information we came across from a gentleman called Callum Thomas, who runs Top Down charts.

Below we share some of that information, including a major warning sign for those heavily exposed to equity markets, and a reminder that investments in hard assets are likely to be very rewarding in the years to come.

Those hard assets of course include pink diamonds.

Investors are nervous… and the money is gone

Two charts caught our eye this week, both of which speak to the risk that exists in traditional assets like the share market going forward.

The first of the charts has to do with investor sentiment, which tends to oscillate between fear and greed. It can be seen below, alongside movements in the S&P 500 equity market index, from the late 1980s through to today.

Bullish Surveyed Sentiment
Combined AAII & II Sentiment (1m avg, z-score)

Source: Topdown Charts, Datastream.

Right now, investors are very pessimistic.

In the very short-term, this may in fact mean markets will bounce, but there is no doubt the mood of investors has changed in 2022.

Instead of “buy the dip” (meaning buy shares whenever they fall) it’s “sell the rally”  (meaning sell shares whenever they rise). This is unlikely to change soon, with soaring inflation, a pullback in technology stocks, talk of multiple interest rate rises and the ongoing tensions between Russia and the Ukraine all problems for investors to navigate.

Moving on from sentiment, the other warning sign we came across is to do with liquidity, or the lack thereof in the markets today.

This can be seen in the chart below which again plots the S&P 500 (pink line) and an equity market liquidity measure (blue shaded area).

Liquidity is critical to markets, with sharp declines in it often coinciding with, and indeed contributing to the major share market collapses of our time.

In the last couple of months, liquidity has been dramatically reduced, which is quite concerning given the pullback in the share-market has been fairly modest to date.

We certainly haven’t seen anything like the Global Financial Crisis, or COVID crash, but with far less money sloshing around the market, the risk is obvious.

Combined, heightened investor caution with lower liquidity mean that in all likelihood, share markets are going to be both substantially more volatile, and far less rewarding for investors going forward.

Indeed, when factoring in other issues like stretched valuations (which we will write about more in time), there is a very good chance returns in share markets could be negative over the next five to ten years, especially once inflation is factored in.

That’s a huge reason to look at alternative assets to hold in your portfolio.

Stay the course with hard assets

While the risks to broader equity markets become clearer by the day, pockets of opportunity remain.

That much is made clear when looking at the chart below, which shows the valuation (what investors are currently paying) to be an owner of energy and metals (i.e. commodity) producers, relative to the broader S&P 500 equity market index.

As you can see, it is at a more or less one hundred year low, with the price of energy and metals producers having never been cheaper on a relative basis.

This is unlikely to last, as markets always tend to revert to the mean over time.

A one in a hundred year opportunity?
Valuation of energy/metals companies relative to the S&P 500

As of 31/12/2021. Source: S&P, MSCI, Moody’s, GMO. Valuation metric is a combination of P/E (Normalised Historical Earnings), Price-to-Book Value, and Dividend Yield.

While this chart obviously looks at the price of companies that are involved in the production of hard assets and commodities, it has a spill over and a relevance to the hard assets and commodities themselves.

A world in which the share price of commodity producers rises relative to other parts of the market is almost certainly a world in which commodity prices themselves are rising substantially.

That is likely to be particularly true for those hard assets that are genuinely scarce on the supply side, and those that offer diversification benefits to investors due to the fact their price behaviour, and demand drivers, are uncorrelated to the broader economy.

There is no hard asset that fits the bill more perfectly in that regard than pink diamonds, with the historic cheapness of commodity producing companies relative to other parts of the market yet another tailwind for this unique asset class in the years ahead.

As always, we hope you’ve enjoyed this week’s edition of “In the Loupe” and we look forward to any questions or comments you may have.

 

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