The stock market reached new highs this quarter, and our accounts continue to perform well in this bull market. Below, we share our thoughts on what’s happening in the financial world.
In our last letter, we discussed tariffs extensively. In April, the stock market was down nearly 20% due to concerns over Trump’s proposed Liberation Day tariffs. Today, we’ve recovered all those losses and more. What changed? As of this report, the economy is slowing but not in a recession. In April, the market was convinced we were headed for a severe recession or worse. We don’t believe a recession will occur, which is why we didn’t sell any stocks to prepare for one.
Our best guess for what’s next is a period of inflation or even stagflation. We define stagflation as selling fewer units while the price of those units rises rather than falls. We believe this is the most likely outcome based on current policies. We don’t expect rampant inflation (over 6%), but we do see it staying above the Fed’s 2% target. This persistent inflation above 2% will force the Fed to choose between protecting the dollar’s value by keeping rates high or lowering rates to boost unit sales. We’ve repeatedly stated that we think the Fed will cave, printing money and lowering rates to stimulate the economy, even with inflation above 2%.
To profit from the anticipation that the Fed might yield to political pressures, we look to the price of gold. Our investment in Royal Gold stock, made over five years ago when gold was under $1,500, has paid off well, with gold now at $4,500. Gold acts as a hedge against uncertainty and poor fiscal governance. The U.S. continues to spend $7 trillion while collecting only $5 trillion in taxes—a fiscal policy we believe is unsustainable. Hence, gold is at new highs. Our view of returning inflation and rising commodity prices isn’t new for long-term clients. Wall Street’s prevailing wisdom is that inflation will be contained. We disagree over a ten-year horizon, though it might hold for the next two years. Let us explain.
The current administration emphasizes “drill, baby, drill” when discussing oil. There’s a reason for this: energy prices significantly impact the CPI, PCE, and PPI indices that Fed officials use to gauge inflation. If oil prices rise, the likelihood of the Fed cutting rates drops sharply. Higher oil prices would also make it harder for the government to fund the $2 trillion it borrows annually. The previous administration, less enthusiastic about drilling, reduced oil prices by draining 35% (250 million barrels) of the Strategic Petroleum Reserve. They weren’t alone in depleting oil storage; global and U.S. oil inventories are near record lows. There seems to be a consensus that oil prices will never rise significantly. We’ve been wrong in predicting a sharp increase, but with global oil inventories so low, President Trump is pushing to keep prices down by encouraging more drilling. We doubt oil companies are eager to drill with oil at $60—they’d be more motivated if prices exceeded $90. We believe that’s the level needed to spur increased U.S. oil production. Why will oil prices rise?
We track the price of oil relative to other commodities to identify what’s undervalued. Historically, the S&P 500 divided by the price of a barrel of oil has a median ratio of 27 (using data since 1991). Today, that ratio is 105, meaning stocks are four times more expensive relative to oil than their historical norm. Commodities typically represent about 14% of the S&P 500; today, they’re at 5.5%. Tangible assets are cheap compared to stocks. The only commodity near its historical range relative to stocks is gold, with the S&P 500-to-gold ratio at 1.78 times, compared to a historical 1.45 times—not too far off. How do we profit from this?
We’ve owned oil stocks for five years. They haven’t been stellar performers, but they’ve been decent. These stocks are cheap (on a cash flow basis) and undervalued relative to other assets. We love unloved stocks, and this group qualifies. When you see Exxon, Shell, Occidental, or Transocean in your account, these are direct bets on rising oil prices. We also hold indirect plays.
Over 30% of BGC’s revenue comes from oil trading, and they’ll benefit from increased volatility in oil and commodity markets, which we expect to occur. Berkshire Hathaway has a significant pipeline business, a substantial stake in Occidental Petroleum, and owns MidAmerican Energy, aligning with this theme. Berkshire is sitting on over $350 billion in cash, waiting for “something” to happen. Nobody knows when volatility will spike, but it will. We’re aware that BGC and Berkshire are large positions in our accounts. The good news is they’ve grown significantly, and we believe there’s more upside, which is why we’re holding them in size for now. BGC and Berkshire are our cheapest stocks on a cash flow basis—an important metric for us—and we expect their cash flow to keep growing, supporting their stock prices.
We also want to address the AI craze. We’re skeptical that all companies building data centers will see profits. The proposed spending on energy and Nvidia chips likely exceeds $1 trillion, but the revenue in this sector doesn’t justify it. We believe AI will be a massive disruptor in how the world operates, but we struggle to see how investors will earn a decent return on that trillion-dollar investment. We reserve the right to change our view, but that’s our perspective today.
Our Christmas party is on December 18th at Highland Springs, from 6 to 8 p.m. The format is the same: come when you want, leave when you want, and drinks and meals are on us. Let’s have fun!
Mark Brueggemann IAR Kelly Clift IAR Brandon Robinson IAR