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The Big Picture

by Victor K. Lai, CFA


2018 ended with a lump of coal instead of a Santa rally for the markets. Losses were not particularly large but were widespread. Prices in every major asset class from stocks and bonds to commodities were down for the year. Emerging market stocks led the way, down -18.1% and even US Treasury and gold prices dipped -0.5% and -4%, respectively. The bears are out prowling and have markets wondering if this is the next big crash. Nobody knows for certain, but I’ll share my thoughts in this letter.


First, let’s review my calls from 2018. As usual I was both right and wrong. My opinion on digital currencies was spot on. I expected the crypto bubble to burst and it did, spectacularly. BTC was down 72% YTD and was far from the biggest loser. I was also correct with my call for increased US stock market volatility. I wrote volatility was the only significantly undervalued opportunity I saw and recommended going long the VIX. The VIX spiked over 400% from January to February and closed the year up 132%!

On the other hand, my preference for both US energy stocks and emerging market stocks were just wrong. Even though both positions started the year off strong, they turned decidedly negative during the year. Energy stocks were dragged down by sinking oil prices and emerging market stocks have been hit with a litany of negative headlines.

For the record, I wasn't thrilled by either position. I wrote buying energy stocks would be like "wearing the least smelly of the dirty laundry." As for EM I wrote, "To be clear, US, EAFE, and EM equity markets all look overvalued at present, it's just emerging markets look the least expensive."

Regardless, in the end, I was simply wrong on both. As the saying goes, hindsight is 20/20, and it’s the looking ahead that gets distorted. I'll have a few more distortions to share for the year ahead. But before that, let's address the elephant in the room.


Stock market selling seemed relentless in the 4th quarter and volatility continues to have investors on the edge of their seats. Is this the start of the next massive crash? Nobody knows for sure but the flurry of scary headlines and rising market volatility sure makes it feel so.

In times like these, it helps to take a step back from the noise and to take a good look at the big picture. Figure 1 below shows annualized volatility for the S&P 500 (measured by standard deviation) for the past 5 decades compared to 2018 and 2017. Notice over long periods (decades in blue), volatility has been fairly consistent with an average read of 16% to 17% per year. In 2018 (red), volatility came in at 16.69%. This read is actually very normal.

Figure 1

Source: Robert Shiller Online Data, Yahoo Finance, BCM

Another measure of stock market volatility, the CBOE Volatility Index (aka the VIX or the “fear index”), also shows volatility near long-term average levels. Figure 2 shows the VIX from 1990 to 2018. The year-end read of 25 is higher than average, but not abnormal and far from extreme levels seen during periods of duress like the financial crisis or the dot com bust.

Figure 2

CBOE Volatility Index

Source: Macro Trends

But again, this sell off doesn’t seem normal, and investors seem very anxious. There are at least a few reasons why this drawdown may feel especially acute.

  • Going back to Figure 1, notice that 2017 (grey) was the real anomaly. Volatility was abnormally low, coming in at just 6.26%.

  • Prior to 2018, the US stock market rallied for about 2 years without even a single correction, this was also abnormal.

  • 2017 was the first “perfect year” for the US stock market ever, the market posted gains every month in the calendar year.

  • US stocks have been on a raging 10-year bull market that is arguably the longest market rally in US history.

Having these reference points as our closest anchors creates lopsided expectations. Investors have grown complacent and used to markets that only go up. Clearly, that’s not realistic. Markets are volatile, they’re supposed to be, and what we experienced in 2018 was a return to more normal levels.


But that doesn’t make the volatility any less scary. Again, in times like these, it helps to focus on the big picture. In this context, I’m talking about the economy. The big, macro-economic picture matters because the stock market is ultimately a reflection of the economy. They’re not mirror images, of course, and don’t move in lock step, but over time the two tend to move together. This makes logical sense because the companies that make up the stock market derive their revenue from the economy.

Most people know this intuitively, but seeing is believing and Figure 3 shows the relationship well. The blue bars show the quarterly returns for the US stock market from 1967 to 2018 (represented by the Wilshire 5000). The grey areas show recessions, there were six. Notice every single recession in modern history was accompanied by a major drawdown in the stock market. That doesn’t mean markets don’t fall during economic expansions, the Black Monday crash of 1987 (blamed on program trading) is one example. But, by and large, the deepest, longest, and nastiest drawdowns have always corresponded with recessions.


This is useful because economic conditions and cycles move much slower and are more practical to forecast than short-term market movements. Staying apprised of economic conditions helps us differentiate the deep drawdowns, from the ebbs and flows of normal market volatility. Simply stated, market sell-offs that occur when the business cycle is expanding are more likely to have limited magnitude and duration, and less likely to be the massive crashes that people fear.

As of now, fundamental data continue to show economic conditions and the business cycle are doing fine. For example, first, employment, one of the most important factors behind economic growth, remains strong. Figure 4 below shows historical data for Initial Jobless Claims, a reliable leading indicator for unemployment and the economy (lower is better). The most recent reading is close to the lowest levels we’ve ever seen.

Figure 4

Initial Jobless Claims

Source: Macro Trends

Second, despite all the hoopla and concern about rising interest rates and an overly aggressive Federal Reserve, interest rates remain low from a historical perspective. Figure 5 shows the 10 Year Treasury Yield since 1962. The yield is back below 3% and still close to the lowest they’ve been in the past five decades. All else equal, low rates are simulative for the economy.

Figure 5

Third, corporate earnings remain strong. This is particularly germane to the stock market because stocks are priced against earnings. Figure 6 shows year over year EPS growth for the S&P 500. As of the most recent data, growth is not just solidly positive but also well above the average growth of the past two decades. While earnings growth is expected to moderate over the next year, it is not expected to contract. Slowing growth still moves in the right direction and still reflects an expanding economy.

Figure 6

Many other indicators confirm that economic conditions are healthy. The most recent GDP data supports this view and show continued expansion. Figure 7 shows annualized real GDP growth by quarter. The most recent reading of 3.4% was again above the 2.3% average of the current expansion. The bottom line is the fundamental data do not reflect imminent recession and that mitigates the chances the current selloff will cascade into the huge crash that people fear.

Figure 7


Last year I wrote compelling values were increasingly hard to come by, and while valuations marginally improved from the global sell-off, that’s still mostly the case today. That puts us back in the precarious situation of seeking relative values in the year ahead, I share my ideas next.

Emerging markets part deux

I was wrong on EM in 2018, or at least my timing was. Valuation-wise, I still believe EM equities represent a better value than US stocks. Yes, I wrote economic conditions in the US look fine, and US equity prices are lower now, but I still don’t see US stocks as a good value. They’re just less expensive than before.

Within the big EM names, I think the Chinese equity market should be of interest. The Chinese market sold off hard and was down 30% from its February high, plagued by a litany of negative headlines - the trade war, slowing growth, sluggish manufacturing, real estate concerns, rising debt, etc. Figure 8 shows 2018 returns for the Chinese and US stock markets represented by FXI and SPY, respectively.

Figure 8

At this point both sentiment and expectations are quite low. Meanwhile, the underlying fundamentals simply don’t look as bad as the headlines sound. In fact, relative to the US, China’s economic statistics look pretty good. At the same time, Chinese equity valuations look increasingly better versus the US. Figure 9 shows select economic and valuation data for China and the US.

Figure 9

Valuations represented by FXI and SPY ETFs; Source: Trading Economics,, BCM

Time for Turkey?

Looking beyond the big BRIC in EM, the most undervalued EM name I see right now is far less-followed Turkey. In 2018, the Turkish stock market was down about 70% from its 2011 highs. This was, in large part, driven by the plummeting value of the Turkish Lira which was down 90% against the US Dollar from its own peak, shown in Figure 10.

Figure 10

The sell-off in Turkish stocks gained momentum in 2018 due to the broader EM sell off and was exacerbated by hot inflation numbers. The spike in inflation increased pressure on the Lira and investors began fearing Turkey would be unable to pay its external debts. Investors feared a financial crisis and capital outflows took off.

Yes, things could get worse before they get better in Turkey. But even if things do balloon into a Turkish financial crisis, it would not be the first time. Turkey has had one financial crisis every decade for the past thirty years. Each time Turkey has surfaced intact and its stock market has followed with a v-shaped rally. Despite the fear mongering about Turkey, taking a step back makes the situation less scary.

First, the Lira has been falling for the last decade and looks relatively cheap versus the Dollar. In contrast, the Lira looked relatively expensive versus the US Dollar heading into the previous crisis of 2008. With the US now expected to pause interest rate hikes, a weak but strengthening Lira (vs USD) would support Turkish stocks.

Figure 11

Second, Turkey has been one of the fastest growing emerging markets, trending an average growth rate of 7% per year. Despite its current issues, it seems unreasonable to assume Turkey is permanently off that long-term trajectory. Goldman Sachs includes Turkey in its “N-11,” or list of next eleven countries positioned to drive global growth, much like the “BRIC” countries did in recent decades. Likewise, Fidelity names Turkey to its list of four “MINT” countries expected to achieve substantial long-term growth.

Third, in a world of ever-increasing valuations, the Turkish market is a rare find. Figure 12 shows valuation measures for Turkey versus other major market regions. It’s hard to say Turkey doesn’t look cheap on a relative basis and even harder to imagine that one of the “N-11 / MINT” markets will trade at 5x earnings and under 1x sales indefinitely.

Figure 12

Turkey Relative Valuation

Represented by TUR, EEM, EFA, SPY, ACWI; Source: Thomson Reuters,, BCM

Critics will say “but Turkey has many problems and no upside catalyst which justifies lower multiples.” The argument makes sense, but I think it misses the point. Turkey doesn’t need a complete turnaround or standing ovation, it just needs to do less badly than expected. Right now, the hurdle is low.

For the record, I heard similar arguments against my call long call for Russia in September 2015 (+58% in 2016), my long call for Greece in October 2016 (+35% in 2017), and my long call for Nigeria in April 2017 (+34% in 2017).

Of course, there are risks. Emerging markets are on a wild ride and Turkey will clearly follow the tide both up and down. And should investors continue to lose confidence in Turkey, things will get worse before better for both the Lira and Turkish stocks. If the situation gets bad enough, Turkey would likely need to fall back on the lender of last resort, the IMF, for bailout loans as they have in the past.

One last concern, Turkey’s prior crises corresponded with recessions. This time around, that hasn’t happened, but we’re not in the clear yet. In fact, Turkey printed a negative GDP read in September. It’s still early and we don’t fully know what the impact will be on Turkey’s business cycle, so this is something worth watching closely. All of these issues are uncertain, and none of them are market-friendly, to say the least.

Silver lining

Outside of equity markets, I see value in precious metals, silver in particular. In 2018 Silver prices were down 70% from their 2011 highs. To be fair, precious metals had a huge run into that peak and many people, myself included, thought a pull-back was in the cards. But prices swung to the other side, and in 2018 precious metals were as widely hated as they were loved before.

Figure 13

Silver Prices

Source: Macro Trends

So, what’s up, or going down, with silver. People may expect the primary driver of silver prices to be simple supply and demand, as with any commodity. Yet, the data show otherwise. Not only have silver supply and demand been fairly consistent over the past decade, but there has also been a consistent net deficit (shortage) of the metal. Despite that shortage, silver prices have plummeted during that period. Clearly, there’s some disconnect between price and underlying supply and demand.

Figure 14

There could many reasons for this, but my guess is the disconnect has something to do with inflation and a good dose of speculation. Precious metals are seen as an inflation hedge so speculators typically pile into them when inflation rises and rush out when it falls. It’s pretty clear when we compare silver prices to inflation, shown in Figure 15 from 1970 to 2018.

Figure 15

Notice how silver prices spiked in the late 1970’s when inflation jumped into the double digits. Likewise, prices subsequently collapsed and moved sideways for decades just as inflation did. The financial crisis of the 2000’s is even more revealing. While silver prices rose some during the crisis, they didn’t really take off until 2011. That was long after the crisis and bear market had ended.

Looking closely reveals silver prices didn’t spike until after inflation bottomed and started to rise in 2010. In other words, silver prices were driven by speculation about inflation, not supply and demand.

Of course, we know now inflation remained anemic, but recall in 2010 the Federal Reserve was neck-deep in ZIRP and QE policies that were designed to stoke inflation post-crisis. It was only natural for people to expect inflation to rise. Silver prices spiked with those expectations and collapsed when they were not met.

This is pertinent because inflation expectations are still low and silver prices have remained under pressure. But the reality is inflation bottomed in 2015 and has been increasing since. At 2.2% CPI is still well below the long-term average of 4% and has plenty of room to move. Add tax cuts, trade tariffs, a tight labor market, and a late business cycle, and we have a recipe for hotter than expected inflation with a side of silver upside.

Figure 16

US Inflation Rate

The billion-dollar question is when will it happen? Honestly, I don’t know and I’ve always preferred valuation over timing anyway. But that’s easier said than done for silver because precious metals don’t have earnings, dividends, or cash flows to value.

One reasonable valuation measure is the gold to silver ratio. The reasoning is that both gold and silver are limited, valuable resources with widely recognized monetary value, and as such the two should maintain some range of relative value (think currency exchange). Over the past 100 years, this ratio has averaged 60. In other words, gold has been priced 60 times higher than silver, on average. In modern history, post-gold standard since 1973, that ratio has been about 47.

Figure 17

Gold to Silver Ratio

Source: Macro Trends

In 2018 the ratio was near 80. This is the second highest reading since the end of the gold standard. Based on gold prices of $1200/oz, a ratio of 47 implies silver prices of $25/oz, and about 80% upside from the current $14/oz handle. The table below shows a range of implied silver prices at $1200/oz gold. This obviously very simplistic and I’m not making precise predictions, I’m just pointing out prices look relatively low.

Figure 18

Implied Silver Prices

As always, there are risks. Not only are silver prices notoriously volatile, but rising interest rates create uncertainty. Rising rates not only increase the cost of physical metal investing but also affects the relative attractiveness vs interest-bearing investments like bonds. Rising rates in the U.S. are of particular concern because precious metals are denominated in U.S. Dollars. All else equal, rising U.S. rates can strengthen the dollar and weaken silver prices.

Figure 19

The Fed’s expected rate pause would be a positive. But as long as rates rise due to healthy, real economic growth, silver prices may stay under pressure. However, rising rates explained by hot inflation and widening credit spreads will be a catalyst for upside. I think this is simply a matter of time, but there’s no telling how much. So, bids should be willing to buy, hold, and endure more downside.


In 2018 global markets experienced many unexpected twists and turns. Increased market volatility has many investors anxious, on edge, and expecting the worst. When markets are steeped in fear, it helps to step back from the day to day swings and to focus on the bigger picture. Economic indicators don’t indicate an imminent recession, but that seems to be what markets are pricing in. That suggests the sell-off is being driven by sentiment rather than fundamentals and is unlikely to be the massive crash people are fearing, at least not yet.

To be fair, there are unresolved risks, and if nothing else, we are now another year closer to the next recession. 2019 is likely to see continued volatility and the next major drawdown is inevitable. So, as the Fed likes to say, we remain “data-dependent.” We will take our cues from economic and market conditions, and will reduce our risk exposure when we see meaningful deterioration across a range of reliable indicators.

Along the way, there are still opportunities for the more aggressive and risk-seeking. The Chinese and Turkish stock markets as well as silver all look to be reasonable values at present. There are plenty of risks, of course, and I don’t know if any of the three markets have found their bottoms yet. What I do know is pessimism is pervasive, expectations are low, and prices look attractive enough to warrant some serious consideration.

Unless these markets go to zero, they will get past their current problems and revert to more reasonable valuation levels. I think long, patient positions at current prices or better will prove to be excellent values. If you take positions, build them over time on price weakness and don’t bite off more than you can stomach (afford to lose).

Thank you for reading, and as always, a special thank you to all our clients. It’s your continued support and confidence that keeps us growing and continually striving to improve. Thank you for always keeping us in mind as a trusted partner and resource for you, your family, and friends. From all of us at BCM, Happy New Year and we wish you the very best in 2019!

Be Great,

Victor K. Lai, CFA

Bellwether Capital Management LLC (BCM) is a registered investment adviser (RIA). It provides investment management and consulting services for people and organizations. Please visit to learn more.


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