Weekly Perspective: The First-Rate Intelligent Investor

We have dedicated a fair amount of this Monday email and our 2021 Market Outlook’s surface area to discussions about frothy sentiment, risk appetite, positioning, and valuations observed in today’s markets.  The peril in focusing on these metrics is that they can engender fear that a top is near, while the metrics themselves offer little in terms of timing what “near” is (1 week? 1 month? 1 year? More?).  This is our caveat that bubble conditions can persist and amplify for some time, mostly when policy is stimulative and tuned to perpetuating these conditions, as it is today.

The result is that we continue to highlight the risks that bubble conditions create for long term investors: higher current valuations tend to lead to lower forward returns, leverage amplifies both the current upside and eventual downside (creating rapid, painful unwinds), and that very bullish sentiment creates a high bar for future upside surprises.  While at the same time we note that things could still get even more frothy given the policy and momentum backdrop.  This is a balance between not taking timing cues where they don’t exist in order to lessen upside risks (being uninvested in a bull market), while staying disciplined (not being drawn into justifying narratives) and being prepared and positioned for downside risks that are intensifying (raising cash after high flying returns, structuring downside protection).  Thus, investors will be required to have that “first-rate intelligence” that F. Scott Fitzgerald described: “the ability to hold two opposed ideas in mind at the same time and still retain the ability to function.”

In thinking about bubbles and timing, we found the following segment from Morgan Housel’s The Psychology of Money to be a poignant and unique perspective that is worth your read:

You can say a lot about these investors [those participating in speculative asset price bubbles].  You can call them speculators.  You can call them irresponsible. You can shake your head at their willingness to take huge risks.

But I don’t think you can call all of them irrational.

The formation of bubbles isn’t so much about people irrationally participating in long-term investing.  They’re about people somewhat rationally moving toward short-term trading to capture momentum that had been feeding on itself.

What do you expect people to do when momentum creates a big short-term return potential?  Sit and watch patiently?  Never.  That’s not how the world works.  Profits will always be chased.  And short-term traders operate in an area where the rules governing long-term investing—particularly around valuation—are ignored, because they’re irrelevant to the game being played.

That’s where things get interesting, where the problems begin.

Bubbles do their damage when long-term investors playing one game start taking their cues from those short-term trades playing another.

Cisco stock rose 300% in 1999 to $60 per share.  At that price the company was valued at $600 billion, which is insane.  Few actually thought it was worth that much; the day-traders were just having their fun.  Economist Burton Malkiel once pointed out that Cisco’s implied growth rate at that valuation meant it would become larger than the entire U.S. economy within 20 years.

But if you were a long-term investor in 1999, $60 was the only price available to buy.  And many people were buying it at that price.  So you may have looked around and said to yourself, “Wow, maybe these other investors know something I don’t.”  Maybe you went along with it.  You even felt smart about it.

What you don’t realize is that the traders who were setting the marginal price of the stock were playing a different game than you were.  Sixty dollars a share was a reasonable price for the traders, because they planned on selling the stock before the end of the day, when it’s price would probably be higher.  But sixty dollars was a disaster in the making for you, because you planned on holding shares for the long run.

-Morgan Housel, The Psychology of Money, 2020, p. 171-172

In the meantime, the wild headlines continue:

• Over 1 trillion shares of Over The Counter (OTC, often “penny stocks”) were traded in December as retail appetite swelled for these securities (see Bloomberg article here)
• Further, a few penny stocks made up a one fifth of U.S. trading volume (see Bloomberg article here) following the release of the $600 stimulus checks (see Bloomberg article here)
• Retail traders on Reddit message boards have sparked a massive rally (short squeeze and gamma squeeze) in a heavily shorted stock after bullish retail traders banded together to fight a short seller (see WSJ article here, see FT article here)
• A TikTok video has gone viral about a couple who describe their “secret” investing strategy: buy when a stock starts going up and sell when it stops going up… but it’s worked (see Bloomberg article here)
• There have already been 67 SPAC deals in January of 2021, 34% above the prior monthly record; there are 300 more on deck; SPAC-mania continues, which is a sign of rabid risk appetite (see WSJ article here)

While calls warning that we are in a bubble are growing louder as well:

• The FT just created a “Runaway Market” series of articles looking at the bubble conditions (see the first article here)
• Bloomberg Opinion’s John Authers examines bubble conditions (see Bloomberg article here)
• Jeremy Grantham of GMO thinks we are in the midst of “one of the greatest bubbles in financial history” (see article here)
• While Goldman doesn’t think we are in a broad bubble, just pockets of excess that don’t pose systemic risks (see CNBC summary here)
• Google Trends shows a big uptick in search for “market bubble” in recent weeks (see Chart 1)

Chart 1: Google Trends Search for “Market Bubble” 

Last Week in Markets: Rotation Pauses, Weak Reactions to Earnings, Junk Rally, Commodity Weakness

Equities

US equity markets rose for the week (S&P 500 +1.21%, NASDAQ +3.28%, Dow Jones Industrial Index +0.02%), with all three indices hitting intraday record highs on Thursday before pulling back on Friday.  The recent two and half month period between election and inauguration days saw the S&P 500 gain 14%, the strongest post-election performance since 1932.

The rotation trade paused last week with smaller cap sizes lagging (Russell 2000 Small-Cap +0.62%, S&P 400 Mid-Cap +0.58%) and Value (-1.14%) significantly underperforming Growth (+3.36%).

There was a fair amount of dispersion in the sector performance.  The week was led by Communication Services (+6.11%) thanks to sharp outperformance from one large media name post earnings.  Tech (+3.36%) also led but saw mixed reactions to the reports of large names.  Real Estate (+2.87%) and Consumer Discretionary (+2.31%) round out the group of leaders.  Lagging sectors were Energy (-5.53%), Financials (-3.57%), Materials (-2.63%), and Industrials (-1.63%).  All of these sectors saw weak reactions to earnings that actually beat analyst estimates, we’ll discuss this below.  After nearly a five-month period of consolidation (side-ways movement) for many of the constituent names, FANG+ (NYSE FANG Index) broke higher and outperformed materially last week (+6.06%).  Lastly, “defensives” largely outperformed with Software (+4.5%) outperforming Semiconductors (+0.61%) and Utilities (+0.76%) outperforming Transports (-3.22%).

On earnings, 13% of S&P 500 companies have reported earnings, with 86% beating and an aggregate beat of 22.4% above estimates, according to FactSet estimates (Bloomberg estimates a 28.2% beat).  It is still early in the season, but this level of earnings surprise vs. expectations is substantial (FactSet’s is the second largest since 2008 records started, while Bloomberg’s is the largest surprise, surpassing even 2Q20’s huge 23% beat).  Interestingly, the price reaction to these huge beats has been negative (we detailed this dynamic of strong earnings and weak price response in last Monday’s note). As can be seen in Chart 2, the overall price reaction to big earnings beats has been negative for the S&P 500 (-1.43%) and negative for all sectors expect Communication Services (which has had only one report and that one had a big positive response).

Chart 2: Big Earnings Beats Being Met with Negative Stock Price Response

Fixed Income

Despite much discussion of further stimulus, and attributing stimulus to equity price moves, rates were little changed last week.  The 10-Year Treasury was nearly unchanged on the week ending at 1.09%, while 2-Year Treasury yields dropped slightly, but just 1 bps (meaning the curve steepened slightly).

Credit caught the headlines instead, with high yield bond markets now on pace for a record January for sales (see Bloomberg article here).  Investors continue to throw capital into ever-riskier asset classes at ever-lower yields in order to hunt for higher returns.  In fact, last week junk bond yields fell to a record low of 4.1%, while yields on CCC debt, the riskiest of the junk bonds, hit an all-time low of only 6.42% (this spiked to 17.5% during the pandemic sell-off, see Chart 3).  This riskiest part of the credit spectrum has been outperforming the “higher quality” junk bonds for the past 11 weeks.  How far we’ve come.

Chart 3: Record Low Yields for CCC (the Lowest Quality) High Yield Debt

Dollar and Commodities

The DXY Dollar index fell slightly on the week (-0.59% to $90.24).  As we have detailed in recent weeks, the dollar is at critical long-term support.  This means a short term bounce off of this level, as we have seen in recent weeks, is quite possible, mostly given how one-sided bearish positioning and sentiment has gotten.  We continue to note longer term factors that could exert downside pressure on the dollar (once this current extreme bearish positioning is worked down): weak long-term trading momentum, U.S. twin deficits/ballooning budget deficit to fund higher fiscal spend, and narrow interest rate differential on a real basis (means investors won’t allocate capital to the U.S. in search of higher yields).   The dollar can have numerous periods of strength and still make its way lower, which could afford investors opportunities to recalibrate positioning into assets that benefit from a weaker dollar regime.

Commodity prices were mostly negative on the week. Industrial metals (-0.86%) underperformed Precious metals (-0.3%), as both Gold (+1.49%) and Silver (+2.92%) were higher on the week.  Energy prices fell on the week with WTI -2.43% to $52.37 a barrel and a natural gas tumbling -8.25%.  Agricultural commodities came under acute pressure (Core-6.32% and Soybeans -8.68%), the largest drop in 17 months (see Bloomberg article here).  This weakness was attributed to strength in Latin American currencies, strong readings on the Brazilian crop, and investors trimming long positions, all despite strong export sales data. Chart 4 and Chart 5 show the 3 Year price action of Corn and Soybeans, respectively.  After a rapid move higher in late 2020, the rally is stalling.

Chart 4: Corn Futures (3 Year Daily)

Chart 5: Soybean Futures (3 year Daily)

Last Week Economic Data: Housing on Fire, Markit PMIs Strong

Housing

The U.S. housing market continues to be a key area of strength in the U.S. economy.  Driving this strength is the Fed’s monetary policy support that has kept long term interest rates low and pushed 30-year fixed mortgage rates to record lows.  Further, consumer preferences have shifted materially following the pandemic, such as surging demand for extra space driving a preference for suburbs of cities.  Other factors like state-level taxes and geographic preferences are spurring buying activity.

December single family housing starts rose +7.9% versus the prior year, the fastest since 2006.  The pandemic impact, can be clearly seen with single-family construction now almost 30% above its pre-pandemic Feb 2020 level, while multi-unit construction is still down 38% from February 2020.

Existing home sales data also was very strong last week (+0.7% MoM to an annual rate of 6.76M units vs. 6.56M cons; +22% YoY).  As can be seen in Chart 6, Existing Homes Sales skyrocketed higher (+32%) after the May 2020 pandemic low, and are now at the highest level since 2006.  Home sales are up +17.4% above their pre-pandemic February 2020 level.  Inventory remains very tight, with only 1.9 month’s supply available, the lowest since 1999.  This tight inventory could put pressure on existing home sales, which is already being seen in the lowest price point homes.  Sales from homes under $250k are down 30% in the past year (where inventory is the tightest), while sales of homes over $1 million are up almost +94% in the past year.

Chart 6: Existing Home Sales At Highest Level Since 2006

Markit PMIs

The Markit U.S. Manufacturing PMI for January rose to 59.1 vs. 57.1 in December (vs. 56.5 cons), firmly in the >50 expansion territory.  Strong demand for goods, tight inventories, and supply chain challenges continue to buoy manufacturing activity.  The Markit U.S. Services PMI accelerated as well, up to 57.5 from 54.8 in December (vs. 54.8 cons).  The Markit surveys show an acceleration in business activity to start the year but are noting intensifying inflationary pressures from higher input prices and supplier delays.  The one weak area in the surveys continues to be employment, mainly in Services where the employment component fell to the lowest level since July 2020.

This Week Data: Fed and Q4 GDP on Deck

• Monday: no major reports
• Tuesday: U.S. Federal Reserve Board starts two-day policy meeting; Case-Shiller Home Price Index; Consumer Confidence (Conference Board)
• Wednesday: U.S. Federal Reserve Board concludes two-day policy meeting; Durable Goods
• Thursday: 4Q20 GDP advanced estimate; Weekly Unemployment Claims; Conference Board Leading Economic Index
• Friday: Personal Income and Consumer Spending; Consumer Sentiment (University of Michigan)

It will be a busy week of earnings with a total of 458 companies reporting across cap-sizes this week and over one-fifth of the S&P 500 reporting.

All eyes will be on the Fed this week as it conducts a two-day policy meeting ending Wednesday with a press conference.  We expect the message from the press conference to echo recent dovish comments from Chair Powell (we detailed these comments in last Monday’s note).  The Fed is likely to continue to signal its commitment to ultra-accommodative, easy policy by keeping both interest rates low and maintaining the current run-rate of asset purchases (though there has been increasing discussion by the Fed Board’s more hawkish members about tapering these purchases given the expectations for much stronger growth in 2021 and additional fiscal stimulus, though for now it appears the doves are making the call given they have “air cover” from elevated unemployment and tepid inflation).  Chair Powell appears to be chiefly committed to avoiding being blamed for any market turbulence from policy “normalization” (like his 2018 experience, Yellen’s 2015/2016 experience, and Bernanke’s 2013 Taper Tantrum).

For 4Q20 GDP estimates, consensus expects a 4.2% annualized increase for the last three months of the year.  This compares to the 33.1% annualized increase in 3Q20 and the 31.4% annualized decrease in 2Q20.  There have been slight decreases to 4Q20 estimates following weaker jobs and retail sales data from December.

International Focus: Eurozone PMIs, Japan Deflation, China Moderating Stimulus

International markets were mixed on the week with emerging markets (+1.27%) outperforming developed markets (-0.57%).

In Europe, the STOXX 600 had a slight gain (+0.17%), led by Germany (+0.63%) but offset by weakness in France (-0.93%), Italy (-1.31%) and the UK (-0.6%).  Bond yields in the Eurozone core rose due perceived hawkish commentary from the European Central Bank (ECB) that it may not use the entire amount available in the pandemic emergency bond-purchasing program.  The Eurozone economy continues to struggle under the weight of the pandemic and lockdowns, with Eurozone PMIs showing renewed weakness in Services in January (45), while Manufacturing (54.7) remains strong (see Chart 7).   In Italy, another political crisis appears to have been averted in the near term, with Prime Minister Conte winning a confidence vote after its coalition partner defected last week.  According to Italian newspapers, a fresh election may still be called due to the thin support Conte received in the Senate.  Yields on Italy’s 10 Year sovereign bond have risen to 0.751% after reaching a record low of 0.51% in mid-December.

Chart 7: Eurozone Services Remain the Weak Spot
Market Manufacturing (Black) and Services (Red) PMIs

In Asian markets, the Japan Nikkei rose +0.39%, despite a report showing that Japan’s consumer prices fell at the fastest pace in a decade (see Reuters article here).  The BoJ remains confident that Japan will not slip back into a protracted period of long-term deflation. South Korea’s Kospi rose another +1.77%, bringing its YTD gain to +9.3%.  Hong Kong’s Hang Seng (HSI) had another strong week (+3.06%, +8.14% YTD).  The HSI is about 11% away from its prior all-time high in early 2018 (which itself was just slightly higher than the prior high from all the way back in 2007).

In China, the Shanghai Composite rose +1.13%.  Full year GDP numbers were released for China, showing relatively strong growth of 2.3% in 2020 and 4Q20 GDP growth of 6.5%.  One area we are watching closely in China is the amount of policy support the government is providing to the economy.  Though the government has not set explicit plans to reduce support to the economy we are starting to see measures like China Credit Impulse (Chart 8) and China M1 Money Supply Growth (Chart 9) start to moderate.  These are important metrics to watch because they typically lead other cyclical indicators/assets (such as China Producer Price Index, YoY Change in Commodity Prices, and YoY Change in U.S. Machinery Stocks, as seen in Chart 9).  For now the Chinese consumer is strong: December retail sales +4.6%, plus an expected +48% increase in Chinese demand for luxury goods in 2020 (according to Bain).  Given the government’s goal to build out a robust domestic consumption economy for long term stability, it is likely the government continues to pursue policies that support this spending.

Chart 8: Slowing China Credit Impulse Could Spell Trouble for Cyclicals 5-6 Months Out
China Credit Impulse YoY

Chart 9: China M1 Money Supply Growth Leads Inflation, Cyclicals, and Commodity Prices
China M1 Money Supply Growth YoY, Advanced 5 Months (Black); China Producer Price Index (Green); U.S. Machinery Stocks YoY Performance (Gold); Bloomberg Commodity Index YoY (Pink)

 

 

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