Great Expectations—and the Thinnest of Thin Ice
The raucous party on Wall Street continued to rage this week with another 0.96% S&P 500 gain to a new all-time weekly closing high of 6,090. At present, the siren song of stocks is hard to resist. Stocks and many other wildly speculative assets just can’t lose, it seems, and the herd is piling in. Along with the S&P 500, cryptocurrencies have been on an epic moonshot, meme stocks are surging again (for no particular reason), and bearish market bets are utterly cratering as U.S. consumer confidence in further stock price increases just spiked, post-election, to the highest level in over 40 years. Virtually everyone suddenly believes there’s nothing but limitless upside to risk-taking at the Wall Street casino. But is it all just a bit too good to be true?
HAI can’t speak for others, but, for this author, piling into financial asset markets at a record 208% total market cap-to-GDP (the famed “Buffet indicator”) is like playing pond hockey on the thinnest of thin ice. It’s an absolute blast right up until it’s an existential disaster that’s altogether the wrong sort of exhilarating.
It’s not just the Buffet indicator warning of extreme risk due to excessive valuations. Tobin’s Q ratio, a measure of market value relative to the replacement cost of assets (book value), is also signaling record extreme premiums paid for underlying asset replacement value. Furthermore, according to legendary market analyst John Hussman, the U.S. equity market has now “reached the most extreme level of valuation in history based on the measures we find best correlated with actual, subsequent 10–12 year returns across a century of market cycles… The recent level [of valuations] exceeds every previous extreme, including 1929, 2000, and 2022.”
Amid this seemingly enormous risk of unexpectedly falling through the thin ice, Bill Gross, the retired bond king with a sense of history, doled out some sage advice to the increasingly risk-forward and hard-partying crowd of speculators. As Gross put it, “I am heeding this herd wave but am wary of circumstances that may slow or end this party.”
Like Gross, in the context of the post-election surge of extreme risk taking, HAI is wary of circumstances that may slow or end this party. And we’re not alone. In fact, Mr. Buffet’s own Berkshire Hathaway has been fading the market melt-up with net stock sales that have exceeded $127 billion year to date, marking the most aggressive selling in Berkshire’s history. Now, record high valuations are not a short-term timing indicator. They are, however, an indication that, relative to history, current market value is based on the greatest of great expectations. So, again, the question today is, “is it all just a bit too good to be true?” And what could disappoint some seriously great expectations?
Some of the fuel for today’s great expectations is undoubtedly the market perception of a new Trump administration that’s seemingly set to right all national and global ills, usher in the next iteration of a “Reagan Revolution,” and once again manifest “morning in America.” To be clear, HAI sincerely hopes the reasons for such optimism are indeed realized over the coming years, but, as the Gipper himself said, we must “trust but verify.”
In deference to that advice, let’s spotlight Treasury Secretary nominee Scott Bessent and examine his proposed agenda for a successful Trump presidency. Are great expectations justified, or might we be wise to expect some consequential bumps in the road?
At a Manhattan Institute economic summit in June, Reihan Salam asked Bessent, “If you were advising, let’s say, Donald Trump were he elected president and he’s in office in 2025, what would you suggest as the three arrows for a successful presidency?”
Bessent responded that his “three arrows” for a successful Trump presidency would be 1) 3% real economic growth, 2) get the deficit down to 3% of GDP by the end of his term (from roughly 7% today), and 3) 3 million more oil barrels equivalent a day from U.S. energy production. As Mr. Bessent put it, “…that would be my 3, 3, 3.”
So, let’s examine each of the three arrows, starting with the first arrow of 3% real economic growth. The fact is that for the past 25 years, almost all instances in which the U.S. approached or exceeded 3% real GDP growth have been periods where we’ve also had 6-8% deficit growth, not significant government spending cuts. Given the current construct of the U.S. economy, it seems that ongoing deficits of $2-$3 trillion per year are far more consistent with a goal of 3% real GDP growth than a fresh wave of DOGE inspired austerity.
Additionally, Federal deficit cuts, or the aggressive use of U.S. tariffs (as has been much discussed) would also likely initially put significant upward pressure on the U.S. dollar, which would also slow U.S. GDP growth and bloat the deficit—in both cases, potentially dramatically.
In other words, Bessent’s goals of arrow #1 (3% real GDP growth) and arrow #2 (to bring the U.S. deficit-to-GDP ratio down to 3%) appear—at least for a long enough time to matter—extremely contradictory. So, if Elon Musk and Vivek Ramaswamy can make traction on the new DOGE initiative, and they can influence a meaningful reduction in government spending, such progress, initially at least, would likely come at the cost of lower rather than higher real GDP growth. Additionally, as past HAIs have detailed, lower GDP growth in our heavily financialized economy would likely mean that tax receipts drop disproportionately more than what is saved in government spending cuts – a dynamic that translates to higher rather than lower deficits.
Furthermore, even in the unlikely event that 3% real GDP growth could be achieved in spite of the headwinds of Federal spending cuts and a stronger U.S. dollar, 3% real GDP growth would likely stoke current secular macro dynamics already supporting higher levels of inflation. By extension, another impulse of higher inflation and inflation expectations would likely drive higher U.S. Treasury yields, and that would act as another drag on growth as well as further bloat deficits due to a rising interest expense. Again, the market seems to be dramatically underestimating the inherent difficulties involved in attaining both an increase to 3% real GDP growth and a decrease to 3% deficits-to-GDP.
So, if this exercise represents a circle that’s very difficult to square, then does Bessent’s arrow #3 (3 million more oil barrels equivalent a day from U.S. energy production) hold the ultimate key to the success of his plan? After all, Bessent strongly implied in his Manhattan Institute comments that his plan for increasing oil production was indeed a key facilitator for both increased U.S. GDP growth and reducing the deficit. He said of the hoped-for increase in oil production, “That would substantially decrease the oil price. That’s one of the number one drivers of inflation expectations. And then back to the Fed, they could go into a proper easing cycle.” In other words, Bessent’s idea is that with added oil production, prices will fall. Then, if oil prices fall, inflation and inflation expectations will fall. And if inflation is no longer a concern, the Fed can “go into a proper easing cycle.” The implication is that a proper easing cycle will be a key driver for GDP growth and a lower interest expense that will lower the deficit. So, voila! There you have it. Significantly increase U.S. oil production and the “three arrows” will work beautifully. The raucous party on Wall Street will be justified, as a bright new morning in America is only a month away! We can hope, but, in HAI’s view, don’t be so sure.
U.S. shale is the world’s biggest high-cost oil producer, and it has been responsible for nearly 90% of non-OPEC+ oil production growth over the last decade. Unfortunately, however, U.S. shale has a newfound depletion problem. Given rapidly increasing decline rates, shale needs increasingly higher oil prices to produce profitably. A ramping up of production that lowers oil prices will be self-defeating and ultimately lead to lower shale production.
As a Wall Street Journal article titled “Trump Treasury Nominee’s Oil Math Doesn’t Add Up” highlighted last week, the dynamics now present in the U.S. oil patch challenge the practicality of a “drill, baby, drill” approach that can stimulate the economy through a notable drop in energy prices. As the article noted, “U.S. energy companies on average say they need WTI crude prices to be at least $65 a barrel for drilling to be profitable and $89 a barrel for them to increase drilling substantially, according to the latest survey by the Kansas City Federal Reserve. With prices today below $70 a barrel, there is scant incentive for drillers to increase production.”
And it’s not just the WSJ voicing skepticism over the all-important arrow #3. This week, HAI favorite commodity research firm Goehring & Rozencwajg opined that, “President-elect Trump’s ‘Three Arrows’ energy plan prominently promises a 3-million-barrel-per-day increase in US oil-equivalent production. But we see this optimism as misplaced. The primary forces behind the current downturn [in U.S. shale oil production] are neither policy related nor purely economic—they are geological and inexorable. Depletion, not market dynamics or regulatory overreach, is the central culprit. Admittedly, the incoming administration features several well-informed and capable figures in the energy sphere, including Chris Wright and Scott Bessent. Their leadership will undoubtedly foster a favorable climate for drilling activity. Yet, even with their expertise and the administration’s likely zeal for energy development, we remain convinced that these efforts will struggle to offset the entrenched declines now gripping the shale sector. The geology of the shale patch has spoken, and its verdict seems increasingly final.”
The key takeaway of the “three arrows” analysis above is that, if one pulls back and widens the lens, it becomes clear that, post-election—just as pre-election, the policy aim most consistent with supporting both arrow #1 and arrow #2 (stronger growth and deficit reduction) is a significantly weaker dollar and substantially lower real interest rates. If arrow #3 (significantly increased U.S. oil production) can’t successfully lower oil prices and kill inflation, then we’re right back to where we were pre-election—a U.S. political will to weaken the dollar and reduce interest rates despite the likely release valve of higher inflation. That’s a scenario that would be good for gold, but may well upset the equilibrium of a stock market priced for the perfection of great expectations.
Furthermore, we know that in every previous historical example of wildly excessive market valuations, gold has outperformed over the years that follow. In HAI’s view, now is a time to respect this week’s wisdom from Bill Gross: heed this herd wave, but be wary of circumstances that may slow or end the party. With great expectations fully priced in, it could be something as obscure as uncooperative U.S. shale patch geology that puts the pin to the most epic financial asset bubble of our time. Even amid post-election optimism and the hopes for an imminent morning in America, caution and golden financial insurance are advised.
While the siren call toward the seemingly easy gains of an ongoing record 208% market cap-to-GDP bubble can be hard to resist, HAI is of the view that we are still in the early stages of a gold bull market that will run for years. Unlike stocks, however, the post-election correction in the yellow metal offers a golden—if undervalued—opportunity founded on hard rock. Can’t say the same for financial assets precariously perched on the thinnest of thin ice.
Weekly performance: The S&P 500 gained 0.96%. Gold was off 0.80%, silver gained 1.54%. Platinum was down 2.13%, and palladium was down 3.00%. The HUI gold miners index was down 1.60%. The IFRA iShares US Infrastructure ETF was off 2.58%. Energy commodities were volatile and lower on the week. WTI crude oil lost 1.39%, while natural gas lost 8.53%. The CRB Commodity Index was off 0.21%. Copper gained 1.36%. The Dow Jones US Specialty Real Estate Investment Trust Index was off 2.62%. The Vanguard Utilities ETF was down 3.83%. The dollar index was up 0.32% to close the week at 106.04. The yield on the 10-yr U.S. Treasury was down 1 bp to close at 4.17%.
Have a wonderful weekend!
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
