2017 Outlook

Welcome to 2017.

​Expect market volatility to creep higher into the New Year as investors take profit. I am positioned for a rise in long-duration Treasury bonds, which appear extremely oversold near a support zone. My current holdings are starting to reflect the base-case of complacency along a cycle shift. I begin with a look at the implied market risk premium, which was mentioned by Bundesbank VP Claudia Buch in a November '16 interview. Buch stated that a low ERP reflects a false sense of security that is tied to a period of prolonged monetary easing. The combination of stretched U.S. equity valuations and several indicators of complacency results in a bullish outlook on Gold and international equities vs. government bonds. 

​Click on charts to expand view

Markets do not reflect underlying risk 

​The decline in equity risk premium reflects a false sense of security. The ERP measures the expected return that equity investors demand over and above a risk-free rate. Some argue the Federal Reserve engineered a declining ERP; enhanced by prior deflationary forces such as the decline in both commodity prices and government bond yields. Such complacency will likely trigger a greater risk premium as Western economies shift from a period of monetary easing to monetary tightening.

​For example, long maturity loans issued by European banks at such low rates is a concern. Banks will have to pay higher funding costs as short-term rates rise, which narrows the interest margin. The observation by Bundesbank VP Claudia Buch helps us understand the shifting rate cycle, which could be the starting point of a significant unwind of risk. 

U.S. Equity valuations are stretched

​A high level of complacency is also reflected in stretched valuation levels. The Shiller P/E ratio is around 60% higher than fair value, and recently exceeded 2007 levels. Shiller P/E is a valuation metric calculated by price dividend over an average of the past ten years of earnings, adjusted for inflation. Stretched valuation levels suggests a low to negative implied future annual return for U.S. equities.

GuruFocus calculations on the range of future returns if the market valuation is within 50% to 150% of the mean.

​Treasury bonds oversold as yields hit resistance 

​'Equity Bulls' and 'Bond Bears' will continue to take profit into the new year. Investors should come to terms with long-term impacts of a shifting monetary cycle. A rally in long duration Treasury bonds from extreme oversold levels should slow the spike in yields. The chart below shows the 10-year Treasury yield at a key resistance zone. 

​U.S. Equities preferred vs. long-duration Treasury bonds

​A short-term rise in bond prices does not warrant a sudden shift away from equities. The breakout in the S&P 500 relative to long-duration Treasuries will likely re-test support at the start of 2017 and continue an uptrend. 

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Hedge with Gold - further upside ahead

​The final result is a bullish outlook for Gold. An expected rise in market risk premium will trigger a re-pricing of risk assets into a cycle shift. Gold provides an alternative as both bonds and equities remain distorted from a prolonged period of monetary easing. The chart below shows the Gold price positioned at a key support level. If confirmed, a strong upside wave will follow. This is expected as the U.S. Dollar begins a downside corrective phase. With gold as a hedge, the hunt for attractive equity valuation will begin abroad.