Weekly Perspective: Meme Variance Optimization

How do you invest for the long run when there are signs you are in a speculative bubble?  This could be one of the most confounding and yet important questions for investors currently.  As we have discussed at length in recent weeks (see here, see here), investors are facing the difficulty of balancing short-term upside opportunity thanks to momentum, stimulus, and speculative fervor, with medium- and long-term downside and repressed-return risks due to high valuations, elevated debt levels, and widespread optimism (a good article from Verdad highlights how challenging this can be).

The trading of the last few weeks has been fascinating, to say the least: one stock rising over +2,000% in two weeks and subsequently falling 90%, other “meme-stocks” rising rapidly and then quickly losing $36B in market cap (see Chart 1, see FT article here), a collapse and then surge in a digital currency started as a joke (see Bloomberg article here), and retail options volumes hitting records (Chart 2, see article here), to name just a few.  We will likely be discussing and debating the events of the last few weeks of wild trading for some time, whether it is from a regulatory perspective (see Reuters article here) or a commentary on broader socioeconomic issues (see FT article here), but there are two immediate lessons about human behavioral biases that we can observe.

First, human nature is frustratingly static.  For all of the talk of the new retail investor being savvier and more evolved (employing increasingly complex trading strategies and products), participants in this year’s meme-bubble showed that we still haven’t been able to overcome that one driving characteristic of our humanity: greed.  Seeing other people get rich quickly not only propelled traders to chase the returns of the biggest winners (stories of people buying at the peak and losing significant sums of money in the FT article above), but to also desperately seek out, or even create (I’m looking at you, silver), the next big return opportunity.  Seeing stocks go up 100’s and even 1,000’s of percent in a blink can make the NASDAQ’s 95% gain in the last 10 months seem pedestrian.  We lose our framing of what is actually an impressive and historically rare return.  Greed raises our expectations that returns are repeatable and easy, which can make us all too comfortable taking on outsized risk (see this article about resisting the temptation).

Second, this year has shown how mesmerized we can become by narratives and how irrational these narratives can make our behavior.  As we described in last week’s note (see here), there was a powerful overtone of anger and revenge in the meme-stock surge, with battle-cries calling for retribution for the “main street” destruction during the GFC (see article here).  Many participants in the meme-bubble have cited a desire to be a part of this David vs. Goliath story as their reason for buying, “holding the line”, and stomaching major losses.  This is a fascinating wrinkle compared to prior bubbles because it took the dial on the emotional aspect of bubbles and cranked it way up. This took us beyond the level of speculative greed to the level of self-wealth destruction out of principle.

One more thought on recent trading, there is a growing narrative that the meme-bubble was “contained”, only reflected speculative excess in a small portion of the market, and did not mean that the broader market environment was experiencing bubble-like conditions.  We observe far too many traditionally bubble-like characteristics in U.S. equity markets to agree with this assessment.  In fact, we recorded an entire podcast on this topic (see here).  That does not mean we are calling for the imminent bursting of broader froth, but it does mean that we need to remain vigilant and disciplined in navigating these markets.  Take profits in super-normal winners, build up some dry powder for optionality and flexibility, consider layering in portfolio insurance, and if you can, try your best to not be human.

Chart 1: The Rise and Fall of the Meme-Stock

^{Source: Financial Times}

Chart 2: Robinhood Options Trading Volume

^{Source: Robinhood}

Last Week in Markets: Equities New Highs; Long Yields Rise While 2-Year All-Time Low; Crude Rally

Equities

After having their worst week since October the prior week, U.S. equities had their best week since November last week, erasing the prior week’s losses and rising to new all-time-highs (S&P 500 +4.65%, NASDAQ +6.01%, Dow Jones Industrial Average +3.89%).  Smaller cap sizes regained their leadership in last week’s trading (Russell 2000 Small-Cap +7.7% and now up +13% YTD; S&P 400 Mid-Cap +5.84%).  Growth (+5.06%) outperformed Value (+4.73%).

From a sector perspective, all sectors were higher on the week, but the message was clearly pro-cyclical and risk-on. Energy was the leader on the week (+8.29%) helped by a 7.4% increase in WTI crude prices to a one-year high of $57.42.  Financials also were big gainers on the week (+6.59%), led by Banks (+8.4%) which benefited from an over 10 bps steepening in the 10-2 yield curve (an important driver of bank profitability).  Other leaders included Communication Services (+7.26%) and Consumer Discretionary (+5.99%).   Laggard sectors were those with the most defensive characteristics: Health Care (+0.5%), Utilities (+2.26%), Consumer Staples (+2.53%), and Real Estate (+3.16%). While there was clearly a pro-cyclical tone (transports outperforming utilities, banks outperforming utilities, small outperforming large), cyclical Semi-Conductors (+3.39%) did underperform the more defensive Software (+5.26%).

Earnings continued to roll in, with 59% of S&P 500 companies now having reported 4Q20 earnings.  81% of companies have beat analyst estimates, with an aggregate beat of 15.2%, tracking at the third-largest beat to earnings on record since 2008.  Earnings are now tracking +1.7% YoY for 4Q20, compared to an expectation for a -9.3% decline at the time of quarter-end.  If this gain in earnings continues, it will be the first quarter of YoY earnings growth since 4Q19 (see FactSet analysis here).  Chart 3 shows the YoY change in earnings by sector.  The reception to these earnings beats continues to be weak, with an average price decline of -0.64% for S&P 500 companies on the day of earnings.

Chart 3: Industrials and Energy are the Weakest, While Financials, Materials, & IT Show Strong YoY Earnings Growth

^{Source: FactSet}

Fixed Income

Last week saw a few notable moves in the U.S. Treasury market.  First, the 10-Year Treasury rose over 10 bps to 1.18% thanks to expectations for increased fiscal spending and inflation, further stoked by the weaker January jobs report, which investors expect will spur lawmakers to take swifter action to support the economy.  This also pushed longer-dated 30-Year yields higher, which climbed above 2% last week for the first since Feb-2020 (see FT article here).   This rise in long-term yields is catching on through the rest of the world as well, helped by similar dovish and stimulative commentary from international policymakers (see Bloomberg article here).  This rise in long-term yields is being helped by rising inflation expectations: 5 Year forward inflation expectations rose 15 bps to 2.21% last week, the highest level since 2014.  Investors are contemplating if the combination of significant fiscal stimulus (Biden calling for $1.9T of stimulus on top of the $900B from Dec-2020 and $3T from spring of 2020) and very easy monetary policy (rates near zero, $120B of asset purchases a month, plus liquidity facilities) will combine to stoke inflation.  Despite higher inflation expectations, observed inflation measures, the Fed’s preferred tool, stand below the Fed’s 2% target (Core PCE 1.4% in December).

Contrasting the moves higher in the long end of the curve, the short-end of the curve moved lower last week, with the 2-Year Yield hitting an all-time low.  This is the clearest display of the Fed’s ultra-easy stance, as 2-Year Yields usually rise with inflation and growth expectations/observations(such as elevated Prices Paid results in the manufacturing and services PMIs).  Instead, 2 Year yields aren’t budging and are drifting lower.

This suppression of the short end and rising on the long end of the curve allowed for the U.S. Treasury curve to steepen significantly last week.  The 10-2 spread reached its widest level since 2017 (see Chart 4), while the 30-5 spread reached its widest level since 2015 (see FT article here).

Chart 4: Yield Curve Steepens Significantly with Higher Inflation and Stimulus Expectations Pushing Up the Long End and Fed Policy Suppressing the Short End
U.S. Treasury 10-2 Treasury Spread

^{Source: Bloomberg, Fieldpoint Private}

Currencies and Commodities

The U.S. Dollar, as measured by the DXY, strengthen slightly last week (+0.23%, to $91.12).

On the commodity front, the Bloomberg Commodity Spot index hit a six-year high last week (see Chart 5), as commodities across the spectrum rallied on reopening optimism, rising demand, and supply restrictions (see Bloomberg article here).  Industrial Metals (+2.34%) outperformed Precious Metals (-2.07%) due to Gold (-1.65%) and Silver (-6.39%) weakness.  Silver saw the unwind of the retail/Reddit #silversqueeze trade, despite huge inflows into silver ETFs and products.

Chart 5: Bloomberg Commodity Spot Price Index at 6-Year High

^{Source: Bloomberg, Fieldpoint Private}

As mentioned earlier, crude prices rallied sharply last week given a larger than expected drawdown in U.S. inventories (WTI +7.25% to $57.42, a one-year high, see article here).  Analysts expect continued upward pressure on oil prices in the very near term given economic reopening increasing demand, while supply has been cut (Saudi unilaterally cutting production by 1 million barrels per day).  U.S. production growth is slowly responding to these higher prices, but active rig count in the U.S. remains depressed.  With active oil rigs at 299 in the U.S., the rig count is just about 1/3 of where it was back in late 2018 (see Chart 6).  Oil companies are being pressured by shareholders to “live within their cash flows” and remain disciplined on capital expenditures.

Chart 6: U.S. Rig Still Low, Will We See a Ramp-Up in Production as Prices Rise?
Baker Hughes U.S. Crude Oil Rotary Rig Count

^{Source: Bloomberg}

Last Week Economic Data: Jobs Disappoint, PMI Momentum Slows (and what it could mean for cyclicals)

Jobs Data

January Non-Farm Payrolls came in below expectations (49k vs. 105k cons), while there was a 159k downward revision to previous figures.  Private Payrolls only rose by 6k last month. Clearly, the momentum in job gains since the initial reopening of the economy has stalled out (see Chart 7), but there was plenty of debate last week as to how weak this jobs report actually was.  Analysts pointed to seasonal factors depressing January numbers while improving weekly jobless claims data over the past three weeks could signal better jobs data ahead.  Further, the average workweek rose to 35 hours, the highest since 2006, indicating there could be a pickup in hiring in the coming months.

The Unemployment Rate fell to 6.3% (vs. 6.7% prior) but this was due to a drop in the labor force participation rate to 61.4%.  Permanent layoffs also increased last month, while temporary layoffs fell again (see Chart 8 ).  The number of long-term unemployed continues to rise, with those unemployed over 27 weeks now about 35% of the total unemployed (the largest cohort now).

Chart 7: The Recovery in Jobs has Stalled Out
Payrolls in 2020 Recession and Recovery vs. GFC

^{Source: Mizhuho Securites via The Daily Shot}

Chart 8: Permanent Layoffs Rising While Temporary Layoffs Falling

^{Source: Bloomberg, Fieldpoint Private}

PMIs

The ISM Manufacturing PMI came in slightly below consensus but remains firmly in expansion territory (58.7 vs. 60 cons, readings above 50 indicate expansion).  We do see some key components like New Orders starting to peak out (see Chart 9).  This brings up an important point about interpreting PMI data and its impact on stock prices: it is the rate of change in PMI that matters more for equity markets.  This “second derivative” interpretation means that despite still being in expansion territory if the PMI starts to lose momentum/ expanding at a slower rate, cyclical stock prices may start to come under pressure.  Take 2018 for example, when the manufacturing PMI hit a high of 60.8 in February of 2018 and hovered in the high-50s and low 60s through the remainder of the year (see Chart 9).  Conventional wisdom would have said that this should be an extremely robust time for cyclical/manufacturing companies that are leveraged to these growing end markets, and yet cyclical equities, such as select industrials and materials, underperformed the market by over 25% that year.  These stocks were anticipating and pricing in the eventual decline in the PMI (because it is a mean-reverting index), which came in 2019 (funny enough, cyclical equities outperformed in 2019 in the anticipation that the PMI would recover in 2020!).  We recall manufacturing companies being confounded by both their significant stock price underperformance in 2018 during “the strongest industrial economy we’ve ever seen” and their strong stock price outperformance in 2019 during a weak year for manufacturing.  This experience reminds us that the stock market is a forward discounting mechanism, with the rate of change in metrics often mattering more than the absolute level.  We think the PMI going over 60 in January has been one of the drivers of Industrial sector underperformance recently, despite all the talk of manufacturing strength, as investors start to anticipate slowing momentum in PMIs.  Always one step ahead.

Chart 9: Cyclicals Underperform When the Pace of ISM Increases Slows, Despite Being in Expansion Territory
ISM Manufacturing PMI

This Week Data

• Monday: No major reports
• Tuesday: Job Openings and Labor Turnover Survey
• Wednesday: Consumer Price Index, Federal Budget, Wholesale Inventories
• Thursday: Weekly Unemployment Claims
• Friday: University of Michigan Consumer Sentiment

 

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