European Energy Crisis, A look at the U.S. Stock Market and Some Basic Understanding of ETFs

“Democracy is also a form of worship. It is the worship of jackals by jackasses.”

and:

“Every decent man is ashamed of the government he lives under.”

— H.L. Mencken

September 13, Vientiane.

One of the advantages that social media brings to us, is to cover and spread information about our ‘leaders’. It makes it more obvious to everyone, how stupid, detached and wrongheaded they are… and what kind of a clown world we are living in. 🤡🌍

All the lies, double-standards, bad characteristics, errors, corruptions and questionable activities come more rapidly to the light and the public has a chance to be more aware of what is actually going on.

As a consequence, we are witnessing a global deterioration of support for political leaders… for uncountable good reasons!

Here are a few approval ratings for some of our ‘beloved leaders’, showing their popularity — or lack thereof:

• Joe Biden (USA) → 42%
• Olaf Scholz (Germany) → 28%
• Karl Nehammer (Austria) → 26%
• Emmanuel Macron (France) → 31%
• Pedro Sánchez (Spain) → 33%
• Mark Rutte (Netherlands) → 26%
• Micheál Martin (Ireland) → 37%
• Justin Trudeau (Canada) → 38%
• Fumio Kishida (Japan) → 31%
• Yoon Seok-youl (South Korea) → 19%

A democracy is supposed to represent the majority of the population. Whether that’s a good idea or not is another question, but just the fact that the approval rating of all these notable leaders of major democracies is significantly below 50%, should make people think about the implications of that. 😶‍🌫️

Meanwhile, apparently the main villain and obvious psychopath Vladimir Putin enjoys an approval rating of 83%. (I would’t necessarily trust the numbers, but still… hmmm). 🤔

At the same time, former actor Volodymyr Zelenskyy — just a year ago (un)known as the leader of a totally corrupt government apparatus — has somehow become an endorsed and celebrated hero, courageously leading the fight for democracy.

Again, it’s a clown world. 🤡🌍

However, it doesn’t only concern democracies, even the Thai king doesn’t enjoy much popularity anymore.

I recently went to watch “Top Gun: Maverick” (I know, the movie is basically a huge propaganda for the US Air Force and Tom Cruise has dubious religious views… but I still enjoyed the movie and despite his questionable Scientology activities, Tom Cruise is a great actor!). Anyway, before the movies start, Thai cinemas play a propaganda commercial for the king, with euphonious music and glamorous pictures, showing a caring king taking care of ‘his’ people. As I learned, Thai people are supposed to (and formerly also used to) stand up while the commercial is playing…

…nobody did… 🙃

…poor majesty. 👑😞

Here is another little anecdote along these lines: 8 years ago, on my first trip to Thailand, my friend explained to me that you are not supposed to stop a rolling coin with your feet, because the face of the king is engraved on it.
A few days ago, I was in a 7/11 standing in the queue with two Korean girls ahead of me in the line. When they were about to pay for their beers, a coin fell to the ground…

…and started rolling…

…in my mind I was like: “do it, do it, do it”…

…and she did — with determination! 💃😂

…nobody seemed to care… 🤭

…again, poor king. 👑😫

According to my Thai friends — none of them has anything nice to say about him — he spends most of his time with numerous mistresses in his hotel in Germany anyway. So maybe he can enjoy his life nonetheless.

Queen Elizabeth II died last Thursday. In contrast to all the above mentioned, she enjoyed a lot of popularity, both in the UK, as well as around the globe. Moreover, a lot of people even felt the urge to pay tribute to her. I personally have nothing good or bad to say about her, never felt any interest in any royal family stuff, but my guess is that her popularity substantially stems from the fact that she managed to basically stay away from the actual political circus throughout her ‘reign’. ✨👑✨

Let’s turn away from the clown show of low politics for a moment and look at what’s going on in the economy.

This month’s newsletter will cover the following topics:

Part l – Market Analysis

• Key Indicator Rundown
• Winter Is Coming – The Energy Crisis in Europe Is Getting Worse
  • Europe’s Natural Gas Supply
  • The Crisis (Mis)Management
• The S&P 500 Stock Market Index as a Key Market Indicator
  • International Importance of the S&P 500

Part ll – What is an ETF?

• Active Vs. Passive Investment
• Some Actionable Investment Thoughts About ETFs
• Some Final Investment Thoughts

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Part l – Market Analysis

After rebounding in July, the markets have turned back south again, while the economic conditions of the recession keep worsening and Europe is facing severe energy supply prospects for the coming months.

Key Indicator Rundown

• The Natural Gas price has hit alarming levels in Europe with first companies halting their operations. As a response to the heavy sanctions, Russia has now stopped the Nordstream 1 pipeline. With its limited LNG import capacity, Europe is now in a precarious situation. I will dive a bit deeper into the topic below.
• While the gas prices are exploding, oil has gotten cheaper, giving at least a little relief to the economy.
• Month over month Inflation has remained constant throughout July in the U.S. while the yearly number decreased a bit to 8.5%. At the same time, the Inflation in the Eurozone keeps hitting new levels never witnessed in the history of the Euro. The Eurozone inflation rate stands now at 9.1%. As a response, the ECB has now started to follow the Fed in acting more hawkish and has raised its target rate by 75 basis points to 1.25%, to fight the ongoing inflation upward spiral.
• The 10-Year Treasury Rate has risen back above the 3% mark, closing in August at 3.13%. Since then, rates have continued to substantially rise throughout early September. Meanwhile, the yield curve has been inverted for a substantial time by now, with the 2-Year Treasury yield at 3.53% and the 10-Year currently at 3.36% and the 30-Year sitting at 3.51.
• The US Dollar Index has also seen a new 20-year record high, closing in August at 108.86 and briefly spiking above 110 in early September. This upward trend of the DXY further continues to exacerbate the global inflationary impacts, especially in terms of energy prices, given that most energy transactions are denominated in USD.
• Both, the S&P 500 as well as the MSCI ACWI indices have declined by more than 4% in the month of August. However, they have seen tailwinds for the last few trading days.
• CAPE Ratio and the Buffet Indicator both declined alongside the stock market declines. Zooming out, they are keeping at a historically super high level, indicating that — despite the recent declines — based on these indicators, the stock market is magnificently overvalued.
• The volatility index (VIX) keeps volatile and at a historically elevated — although not alarming level of around 25.
• Gold has also kept declining in August closing the month at $1,726. It has been struggling to stay above $1,700 and currently sits at $1,738.
• Bitcoin has lost most of its gains in July back down to the $20,000 mark. Alongside the general trend in the stock markets, it has also seen some price increases over the past days and is trading slightly above $22,000 at the time of writing.

Winter Is Coming – The Energy Crisis in Europe Is Getting Worse

“The economy of imaginary wealth is being replaced by the economy of real and hard assets.”

— Vladimir Putin

There are of course many — mostly negative — things to be said about Putin, but this statement is a pretty good assessment of the current situation. Unfortunately, his European counterpart politicians still don’t seem to grasp the economic realities and therefore keep making the situation worse and worse.

They (Western politicians) are blaming Russia for using its energy resources as a means for economic warfare. As if Russia was the initiator and the villain to blame here. They seem to totally have forgotten who initiated, and is still the main contributor, to this economic war. It was not Russia, but the Western countries, which started (and openly stated) to initiate sanctions, freeze and confiscate assets, in an effort to crumble Russia’s economy.

Just to make sure that nobody misunderstands the point here: Russia started an aggressive and horrendous war in Ukraine, which was a terrible mistake and is by no means justifiable! However, what the West has done in response also has horrific consequences for many people around the world.

The result of it is, that Russia sees herself pushed into a corner and feels triggered to burn the precious natural gas, while the rest of the world is scrambling for energy.

Consequently, Europeans are facing a severe energy crisis with potentially detrimental ramifications. Moreover, it is not only Europe that is suffering the consequences. Other nations are suffering from the supply shortages and rising prices as well. Nations that have stood peacefully on the sidelines now see themselves outbid by European countries which are now purchasing the LNG cargoes that they previously imported. And especially the poorest people, who are on the brink of being able to support their livelihood, are most severely affected by these events.

The ignorance of European politicians in acknowledging their mistakes and stopping their economic war is in my opinion also not justifiable.

Or does an (unclear & questionable) end justify (cruel & devastating) means?

Anyway, since this is not intended to be a newsletter about morals, let’s look at some economic implications.

Europe’s Natural Gas Supply

In the May newsletter, I outlined the difficulties for Europe to import enough natural gas without it coming through the Russian pipelines. It can be read here. Now this eventuality seems to have become reality.

In 2021, Europe imported about 40% of its natural gas supplies from Russia. The particular issue with natural gas is, that it is not so easy to switch the supplier as it is with other resources, such as oil. From the May issue:

While it is possible to shift oil suppliers, it is far more difficult to change sources for natural gas. Oil can be globally transported on tankers while gas is mostly transported to Europe through pipelines. In order to ship gas from other sources, it first needs to be cooled down into liquefied natural gas (LNG). This process is complicated, more expensive and requires an infrastructure which first needs to be set up, requiring time and capital expenditures. Currently, a bit more than 50% of the natural gas is supplied via pipelines with a distinct geographical destination, which is the reason why the gas prices have way higher variations across different geographical areas than oil has.

Furthermore, unlike the oil tankers, that are unspecialized and can easily be rebuilt to serve other functions, the LNG carriers are very specialized in their design. It follows, that the whole production and operation purpose of them, requires a particularized commitment for their intended use.

Here is a chart showing the gas pipelines to Europe:

As can be seen, there are three main pipelines, which supply natural gas from Russia to Europe. The next figure shows, how Russia has cut back on its gas deliveries over the last months, in an attempt to weaponize its resources to fight back against European sanctions:

Now, also the gas via Nordstream 1 (blue in the figure) has been completely halted.

The key problem at the moment, is that Europe just doesn’t have the import capacity of LNG gas sources to fully compensate all of the needed supplies. Hence, it either has to reduce its demand, or shift to other energy sources.

As a consequence, the gas prices in Europe have absolutely exploded over the past few weeks to a point, where the first European companies feel forced to reduce or totally stop their production:

The Crisis (Mis)Management

Faced with these circumstances, what have the European governments done so far, to manage this crisis:

• Several construction projects have been initiated to build facilities to increase the LNG import capacities. → These are good steps, but it will take some time for them to be available, definitely not in the coming winter.
• There are also numerous efforts undertaken, to force the demand downward, by giving various regulations to limit the usage of electricity.→ These help to save energy, but it obviously comes at the price of a lower standard of living. Going back to the caves would be the ultimate culmination of this strategy and would spare Europe from any energy blackouts.
• Providing financial help to support households against the rising prices.→ While it sounds good, this is contradictory to the policies to lowering demand.
  • UK’s new prime minister, Elizabeth Truss, even went so far as to cap the energy bills for household at £2,500. So basically as soon as you reach the mark, you are incentivized to use as much energy as possible.
• Capping profits for energy producers.→ Economics 101: If you want more energy, you definitely shouldn’t take away the incentive to produce it.
• Germany, the largest European economy — and without any doubt taking the first position on the “failed energy leader-board” — is now watched by everybody. There is now a discussion about the three remaining nuclear plants, which currently supply about 6% of German electricity and are scheduled to be shut down at the end of this year. After previously lying to the public, that it is technically not possible to keep them running, Germany’s Minister for Economic Affairs and Climate Action, Robert Habeck, has now changed the course and Germany is seemingly going to postpone the shutdown of 2 of the remaining 3 nuclear energy plants.
  → While this is at least a step in the right direction, so far the plan is to still turn them off, but keep them “in reserve” until April, meaning only to turn them on, if there is an actual energy shortage. Nuclear professionals immediately jumped in, saying that nuclear plants are not built to be switched ‘on’ and ‘off’ like a light bulb, which once more shows just how uninformed the decision makers are about the actual matters at hand.

The sad irony is, that most of these policies will actually backfire and have the opposite consequences of the stated goals. Subsidizing household consumption, while at the same time imposing demand restrictions is a recipe for disaster. Furthermore, I can already see how the UK will be flooded by Bitcoin miners, which are going to take advantage of the free energy, sponsored by the UK government.

In addition, after years of demonizing and disincentivizing the production of fossil energy sources, Europe is facing its day of reckoning. It becomes painfully obvious how important these energy sources still are. Unfortunately, most political ‘leaders’ remain blind to economic realities. Instead of incentivizing energy companies to ramp up their production in the face of the crisis, they are imposing windfall taxes and profit caps.

There seems to be a total lack of knowledge — or pure ignorance — of basic economics. Therefore, there is a good reason to believe, that the European gas prices will remain elevated for the foreseeable future.

Here is the above mentioned German Minister for Economic Affairs and Climate Action again, showing off once more his total lack of basic knowledge about business operations and the situation that small businesses are facing:

The German Minister of Economics, Robert Habeck:
'Bakeries, craft businesses, cleaning companies…. they can just stop producing this year, but they don't go insolvent. They don't work into the red.'#Germany #EnergyPrices #Energy pic.twitter.com/A9poyIZkjk

— TheRealTom™ 🌞 (@tomdabassman) September 7, 2022

To quote Mencken once more:

September 7th 2022711 Retweets2,138 Likes

“Every decent man is ashamed of the government he lives under.”

Politicians are so detached from reality. They live in their own political bubble world, promising the sky to get elected and grab power, and then wield their power over their subjects and cause havoc.

Finally, the lack of natural gas supply, which is primarily used to heat homes and generate electricity, is threatening the quality of life and poses severe danger for the sustainability of many businesses.

The S&P 500 Stock Market Index as a Key Market Indicator

The Standard and Poor’s 500 is the most watched and followed equity index and is the major benchmark against which most hedge funds, fund managers and investors measure their performance against.

Here is a short breakdown of its history:

• In 1923 the Composite index was launched to track 233 American stocks. The number of stocks was increased over the following years. 
• The S&P 500 index in today’s form, including 500 large American companies registered in stock exchanges, goes back to 1957.
• Today the index is considered as the most accurate indicator of the U.S. equity market and is commonly used as the benchmark to measure the performance of individual stocks, other stock indices, portfolios or any other assets.

Technically, the weighting inside the S&P 500 index is according to the respective market capitalization of each company, which summed up represents a huge portion of the entire market value of the entire American stock market.

In contrast, the Dow Jones Industrial Average index (DJIA) is a price-weighted index, which does not take into consideration how much total value each included company represents. This is seen as the main reason why most professionals today see the S&P 500 as a better gauge of the equity market and it is also the reason, why it has overtaken the role as the best representative index of the U.S. stock market.

Some other notable features of the S&P 500 index are:

• Over time companies can be dropped and new companies can be added. This process depends on a committee that evaluates several factors.
• The market capitalization of the S&P 500 is about $35.1 trillion, while the total U.S. equity market cap is $40.9 trillion. Thus, the index represents about 85% of the American stock market.
• Since the contribution to the index is determined by market size, the price movements of large companies have a much higher impact than price changes of smaller companies.
• The statistics are as follows:
  • The top 5 companies represent slightly more than 20% of the index:
    • Apple (AAPL) → 7.1%
    • Microsoft (MSFT) → 5.8%
    • Google (GOOGL) → 3.7%
    • Amazon (AMZN) → 3.4%
    • Tesla (TSLA) → 2.2%(As of October 12th, 2022)
  • The top 40 companies represent about 50%.
  • The remaining 460 companies represent the other 50%.
  • Here is a pie chart that gives a graphic idea about the weighting:

• $100 dollar invested in 1957 was worth about $66,387 at the end of 2021 (assuming that all dividends were reinvested).
  • A yearly return of 10.51%
  • Or a total return of 66,287.09% (The power of compounding!!!)

Here is the chart that shows the performance (recessions are indicated in grey):

Or here is the same chart, but on a logarithmic scale, to provide a better idea about how the tracked companies performed over time percentage-wise:

Another insightful way to look at it, is to not only look at individual companies, but to also analyse the sectors, that contribute to the index valuation, and their relative performance :

As can be seen, the Technology sector is by far the largest (about 30%) and has contributed (together with the Communication Services sector and Consumer Cyclical sector) the most to the overall decline so far this year. On the other hand, the Energy sector, which has seen enormous gains, has not had such a big impact on the overall index, since it only accounts for about 4% of it.

Consequently, when analyzing the movements of the S&P 500, it is important to bear in mind that a) it is largely dominated by just a few companies and b) that different sectors might also behave vastly differently and that this is not necessarily captured by the index.

More generally speaking, a rise in the S&P might indicate:

• A healthy economy with new innovation and rising productivity.
• Global growth and globalization:
  • leading to export opportunities as well as more specialization and improved value creation across international supply chains.
  • Allows foreigners to increasingly invest in the U.S. market.
• Consumer & Investor confidence in the future.
• More risk appetite (selling bonds, buying stocks)
• An expansion of the broad money supply (more dollars chasing the same amount of stocks) → arguably the most significant contributor to the stock market appreciation in recent years.

International Importance of the S&P 500

The U.S. population represents 4.25% of the world population.

The U.S. GDP makes up about 24% of the total global GDP.

U.S. equities account for 40.9% of the global equity market:

While the U.S. GDP is about 30% higher than that of Europe and roughly 60% higher than that of China, its stock market valuation dwarfs both of them by 400%.

There are numerous reasons for this:

• The most influential reason is probably that the US dollar has the status of being the reserve currency. According to the Triffin Paradox, this is why the growing global economy has an increasing demand for US dollars. This in turn also partially explains, why the U.S. have been running an increasing trade deficit over many decades (starting in 1976). The trade deficit means that foreigners hold an increasing amount of dollars which they have to reinvest in USD denominated assets — hence, mainly Treasuries or stocks.
• It is a vibrant and open stock market with deep liquidity, a lot of globally available information and little restrictions to participate.
• The U.S. stock market has also become regarded as the best regulated and most secure stock market over time, also a reason to attract international investments.
• Investing in stocks has always been a main place to allocate capital in America, whereas in most other countries (for example my home country Germany), it just recently has become a more popular way to invest savings.
• Most major innovations over the past 100 years have come from U.S. companies.
• There is a general stock market correlation across the globe, with the U.S. stock market being the leading indicator.

Thus, the S&P not only is an important indicator for the U.S. market, but bears international importance.

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Part ll – What is an ETF?

This is the part of the newsletter where I try to provide some useful knowledge to people who are not yet so familiar with financial terms and concepts.

Since I have often mentioned ETFs and wrote about the S&P 500 index above, it is a good time to look at what exactly an ETF means and how it can be used by investors to diversify risk, while still taking part in the stock market.

The abbreviation “ETF” stands for Exchange Traded Fund.

In a nutshell, an ETF is a basket of several securities. It can be purchased and traded just like an individual stock, but it includes several securities and therefore offers the benefit of diversification.

Most ETFs are structured in a way, to track some equity index (such as the S&P 500). But they can also include other assets, such as bonds or commodities and track all sorts of investment strategies. Examples are:

• Stock Index ETFs (e.g. the SPDR ETF is tracking the S&P 500.)
• Industry ETFs
• Country/Region ETFs
• Commodity ETFs
• Bond ETFs
• Currency ETFs
• Even leverage ETFs (seeking to return more from gains of the underlying assets, but also incur more risk doing so).
• Or Inverse ETFs (betting on the underlying assets to decline).

Active Vs. Passive Investment

ETFs are often compared to Mutual Funds, which is another investment vehicle used for diversification. The difference is, that an ETF usually comes as a passive investment vehicle, which is structured to operate according to a certain predetermined strategy, whereas a Mutual Fund is mostly operated by active money managers.

According to modern portfolio theory and Fama’s EMH (Efficient Market Hypothesis), it is basically impossible for an investor to outperform the market by speculating on individual assets – except for pure luck.

I don’t agree with the EMH theory for multiple reasons, but just statistically speaking, it has been true that — on average — active investors have failed to beat the market. Therefore, following the S&P 500 index seems to be a good way to invest in the stock market. However, an individual investor usually can’t buy and continually rebalance the stocks to track the index. This problem is solved by mutual funds and ETFs.

Over the past 20 years, ETFs have seen rampant growth, while actively managed funds have been declining:

This trend has led to the amount of assets held by ETFs, surpassing that of actively managed capital. Last year marks the first time, that passively managed index funds have overtaken actively managed funds’. Passive funds now account for about 16% of the total U.S. stock market.

The reason for this trend is that ETFs:

• Can charge ultra-low fees.
• Are more liquid and can be traded daily.
• They are transparent in what exactly is tracked.
• Have tax advantages.
• Most importantly, on average active managers have not been able to outperform the market.

Thus, simply investing in the market and sticking to it has generally had the most successful outcome.

However, the past does not determine the future and there are also some specific risks associated with investing in ETFs. The proliferation of index funds, for instance, creates a situation where stocks that are included in an index gain in value just because of their inclusion and not because of actual fundamentals. Taking the position that the stock market is in a bubble, this would mean that there is probably also way more air in the stocks which are included in the major ETFs. Once the bubble bursts, the air could come out quickly and the ‘ETF-balloons” could deflate more substantially than the broad market.

Some Actionable Investment Thoughts About ETFs

When it comes to investing, my personal opinion is that most stocks are probably overvalued and a typical 60/40 portfolio (60% stocks and 40% bonds) is one of the worst possible asset allocations given the state we are in.

Furthermore, as mentioned above, I don’t believe in the EMH (which would suggest something like a 100% allocation in an S&P 500 tracking ETF).

Nonetheless, for a risk-averse investment approach, I still think that stocks should be a part of the portfolio, maybe somewhere between 20-40%.

And despite the above mentioned risks, I think for most people ETFs are the best way to get stock exposure (as compared to giving it to actively managed funds, or picking individual stocks).

In this newsletter I don’t give direct investment advice, since there is just no universally right way to invest. It rather depends a lot on each individual’s circumstances and risk appetite.
My general thoughts about looking for ETFs in the current situation are:

• ETFs tracking the energy sector!
• ETFs tracking commodities and/or commodity producers.
• Some exposure to the U.S. market (I think it is overvalued, however, it can be a risk-diversifier and hedge against the last month explained Milkshake Theory playing out.
  • Moreover, I would look for an ETF with more focus on dividend paying value stocks, and not so much exposure to the IT sector and growth stocks.
• Some exposure to emerging markets. They might face a difficult time with the rising inflation and dollar strength, but as in previous posts explained, I am quite bullish that they will do well over the next decade. (I see it basically as the opposite hedge against the U.S. market exposure).
• Little or no exposure to Europe and Japan — they are in a tough spot!
• No long-term bond ETFs!
• ETFs with Chinese equity exposure — for risk seekers only. I think there is a great opportunity right now in buying Chinese stocks, since they are quite ‘cheap’ at the moment, but there are numerous risks associated with them, which are hard to evaluate.

Some Final Investment Thoughts

Apart from ETFs, I think the most crucial assets to hold are hard & scarce assets, such as land, real estate, gold, and especially bitcoin, which is arguably the hardest asset in the world (it is scheduled to have a higher stock-to-flow ratio than gold after its next Halvening in early 2024).

Additionally, holding some cash (and maybe short term bonds) is advisable as a risk protection and to have some powder for buying at cheaper prices. It is the main hedge against huge asset price downward swings.

I believe that we are in a global recession and the coming months might be quite turbulent.

I am convinced that the major central banks will pivot at some point, but at the moment they are tightening in an effort to (or at least pretending to) fight inflation. Which means, that liquidity is withdrawn and interest rates rise. This puts a lot of pressure on an economy which has gotten used to — and I believe has become dependent on — cheap money and credit expansion!

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Best regards,

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Disclaimer: The content of this newsletter is for informational and educational purposes only. It contains my personal views and opinions, which are not to be taken as direct investment advise. All investments have risks and you should do your own due diligence before making any investment decision. If you require individualized advice, to review your unique situation and make a tailored advice for you, then contact a certified financial planner or other dedicated professionals.

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This newsletter was first published on Substack.