the issue with bonds

An economist I knew years ago made an exhaustive study of the real and nominal returns generated over long periods of time by both stocks and bonds in OECD countries. His conclusion:

–stocks return inflation +6% yearly

–government bonds return inflation +3% yearly.

In today’s world, of low and hard-to-affect inflation, the +x% are probably too high for bonds. It’s harder to figure what to make of stocks, since their returns have been considerably above the +6 pretty steadily since the 2008-09 financial crisis.

Let’s say that the return on a 10-year Treasury should be inflation +1% annually. That would fit 2018 and 2019 experience, when inflation was running around 2% and nominal yields were around 3%.

Where we are now: inflation at, say, 0.6% and the 10-year at 1.45% today. That’s up from 0.6% last summer. However, if we could wave a magic wand and return the US to a pre-pandemic state, inflation would likely be 2%+. That would imply the 10-year at 3%.

If so, we’re a little less than half way back to normal. Given the competence of the current administration, it’s hard to think that the pandemic won’t be increasingly under control as the year progresses. The removal of the prior administration’s growth-inhibiting measures will presumably add an extra tailwind. So my guess is that the bond market will pretty steadily head for 3%. This is a headwind for both stocks and bonds. In the case of stocks, though, the anticipation of strong profit growth will act as a counterweight. This is another reason the stock market is gravitating toward consumer cyclicals, where the greatest positive growth surprises are likely to come from.

market rotation (iii)

what I’m doing

I think a day like yesterday is important to study carefully for what it will tell us about how this year’s stock market will likely evolve. For one thing, yesterday suggests that intraday volatility will likely be extremely high as investors respond to higher interest rates on long-dated bonds.

It would be useful to form an idea of how high the 10-year Treasury yield might get. If we were to suppose that inflation ends up being 1% and the real yield ends up being 2% then the 10-year nominal yield will end up–maybe some time next year–at 3%. I have no confidence that this is anywhere close to correct. But it’s a point to start at and to refine from. It would imply that the PE on the S&P should be somewhere around 33x.

On portfolio structure, my guesses are:

–as evidence mounts that the domestic economy is strengthening more quickly than expected since the beginning of the year, the market is moving away from secular growth names to cyclical recovery beneficiaries, where earnings gains will be the strongest. A shorthand version of this would be to say that the Russell 2000 will likely continue to outperform NASDAQ.

–this doesn’t mean abandoning last year completely. After all, IT + Communication services + Healthcare together make up half the S&P. I see three kinds of stocks among last year’s winners, though: companies that are wholly or mostly beneficiaries of quarantine, and whose growth will shrivel as the country opens back up; companies with new ideas/services whose adoption has been accelerated by the pandemic and will remain important features of life when quarantine ends, but whose growth rate will slow; and companies that are flat-out growers, for whom the pandemic hasn’t made much difference.

My most important task is to get rid of the first group and lighten the second, to shift money into cyclical recovery stocks.

–we can sort recovery stocks into groups as well. There are: the left-for-dead, like airlines and cruise ships and possibly hotels; the immediate beneficiaries of reopening, like bricks-and-mortar retail and restaurants; companies like Lowes and Home Depot, where an end to the pandemic may be bad for business; and firms whose prospects have been damaged by pandemic-induced rethinking of priorities–like the line of ultra-tall, ultra-expensive condo buildings crossing Manhattan just below Central Park.

Personally, I’m most comfortable with retail and dining, but I also hold shares of MAR. I’ve also held a large position in an R2000 etf for a while

–most banks are pure beneficiaries of higher interest rates. Real estate is more complicated, but generally higher rates are not it’s friend.

market rotation continuing (ii)

a starting out note

Less than two months ago the then-sitting president of the US summoned an armed mob to Washington DC in an unsuccessful attempt to intimidate Congress into reversing the results of the November election he lost by a wide margin. Almost as startling, there national Republican luminaries who, although victims of this assault, continue to refuse to affirm that Joe Biden won the election and is the lawful president–dismissing the voices of veteran Republican state election officials who assert the election results are accurate.

As an investor, what I find most notable about is that I don’t see the slightest sign of worry about the coup attempt in any subsequent trading of US equities. Quite the opposite. To my mind, the capital flight trade is no longer the main concern of Wall Street.

My standing assumption is that of all the professional investors I’ve ever known–that the market is always right. So I conclude that Trump is, and will remain, a non-issue for stocks. Why doesn’t matter. The important thing is stock prices have spoken.

think commodities

Typically the stock market shifts from worrying about an economic downturn to anticipating expansion about six months before the economy hits its low point …something government economists will confirm several months after the event.

During the initial phase of a garden-variety up market, the closer a company’s products are to being commodities, the more likely its stock is to have a sharp initial bounce as soon as the market begins to give the “all clear” signal. This move is followed by flattish trading for a while. A second upward movement kicks in only once there’s strong evidence that earnings growth is resuming. That could easily be nine months or a year after the first bounce.

I think that this pattern may hold true for a much larger part of the market than just commodities as the domestic economy begins to recover from covid. How so? I think the pandemic has overwhelmed cyclical downturn defenses, such as having a brand name or appealing to more affluent customers, for virtually all companies.

rising interest rates

Another peculiarity of the economic upswing we seem to be on the cusp of is that interest rates are already rising, to an extent that typically happens only after corporate profits are in full cyclical bloom. The two main issues surrounding rates that I see are: at some point Treasury bond yields will reach a level where individual investors will allocate away from stocks and into fixed income. Where is that level? Not at 1.35% on the 10-year. But at 2.5%? …higher? I don’t think this is a current worry but at some point it will be. Secondly, there’s a kind of rough inverse relationship, in the minds of both the academic and real worlds, between the interest rate on bonds and the inverse of the PE on stocks, which academics all the earnings yield. The idea is that a shareholder’s portion of the current year’s corporate earnings can be looked at as the equivalent of the interest a bondholder gets (even though the earnings remain in the hands of corporate management).

I think the important thing to observe, assuming (as I do) that there’s a germ of truth in this, is that the long bond at 5% is the equivalent of a PE on the market of 1/.05, or 20x. At 4%, the PE is 25. At 2%, the PE is 50. More generally, when interest rates are falling, the market PE expands; at times like now, however, when rates are rising, the market PE contracts.

So unlike the typical bull market situation where rising earnings and falling/steady interest rates reinforce one another, in the current market earnings and rates will likely act as cross purposes.

consider what to sell as well as what to buy

Every major shift in market leadership–and that’s what I think is happening now–should be looked at from two perspectives: who the new leaders will be and how to play them and which former market darlings will be left behind most badly.

On the plus side, it seems to me that the hot spot of growth this year will be the US consumer. Three reasons: fiscal stimulus, Washington acting to fight the pandemic, and a government move to more pro-growth macroeconomic policies. Yes, Americans have been spending a lot while in quarantine, but there’s also considerable pent-up demand, I think, for what reopening will bring. This last is where the the most favorable combination of low valuation and the possibility of surprisingly strong eps growth lies, in my opinion.

Reopening has a flip side, as well. This is the issue of what stay-at-home beneficiaries have passed their best-by dates and should be sold. Prospects for, for example, Etsy, Zoom, Peleton?

In theory, we should all be working on both sides of the portfolio. In practice, we all have different skills and different levels of conviction about potential winners and losers that tell us where we will find the most profitable area to work in.

More tomorrow.

market rotation continuing

important road signs: a recap

The 10-year Treasury peaked at a yield of 0.52% in the middle of last summer. The benchmark bond then began a slow, steady decline (meaning the yield rose) to 0.93% at yearend–a 40 basis point change in six months. The 10-year hit 1.36% this morning, or a 43 bp rise in yield in seven weeks.

The Russell 2000, a measure of the health of US-based companies making and selling bread-and-butter things to US customers, was in steep decline relative to NASDAQ from the day Trump’s big tax cut for his ultra-wealthy boosters went into effect until the November election. Since then the R2000 is up by 39% vs. NASDAQ’s 19% rise.

my interpretation

For bonds, I’m mostly making up numbers. Let’s say a return to a “normal” economy means US yearly GDP growth of 2.0%, with inflation of 1.5%. And let’s posit that bond holders require a real (after-inflation) yield of 2%. That translates into a nominal annual return of 3.5% for lending money to the federal government for a decade. At a nominal yield of 52 bp last July, Treasuries were locking in a real loss of 1% a year for buyers at that point. Sort of like agreeing to pay a bank 1% per year to store your money.

In my view, this was real despair/panic and was related to the US experience with the pandemic.

A second point: on my numbers, we’ve only begun to normalize interest rates. There’s lots more to come.

As to stocks, my take is that the stock market understood much more clearly than the average American how deeply economically destructive the major policies of the Trump administration were. From January 2018 through October 2020, NASDAQ rose by 59%, while the R2000 was barely in the black at +2%.

I take the reversal since as purely conceptual–that is, not based on concrete evidence that the economy is getting better but simply by the notion that what I’ve called the capital flight trade is over and that the worst of the economic damage is behind us. My sense is that the pandemic is a net neutral. We’ve found that the Trump administration actually did much less than its press releases claimed. On the other hand, the vaccination and reopening schedule seems to no longer be vaporware and to be gathering momentum.

More tomorrow.

signs of Spring-metaphor only

We’re bracing for another 7″-8″ of snow tomorrow, following close to two feet last week. But…

A few days ago, the German government announced that it’s preparing to raise interest rates there in reaction to what it expects will be 3%+ inflation there sometime this year. We should note that Germany’s fundamental economic policy–stop inflation at all cost–is a product of its Weimar-era hyperinflation and differs markedly from that of the US–maximum economic growth with moderate, and non-accelerating, inflation. Also the US is still suffering from years of Trump’s economic incompetence. Still. I read this as a signal that we’ve passed the pandemic-induced low point for rates.

The fact that the US has been an economic laggard under Trump suggests recovery here will be longer in coming than elsewhere. The yield on the 10-year note, however, has already risen from 0.93% on January 4th to 1.30% today. If rates in the EU do indeed rise more quickly than here will most likely mean mild depreciation of the US$. If so, US multinationals with large EU exposure would be beneficiaries.

For what it’s worth, Warren Buffett is reported to have sold a big chunk of his AAPL shares and put the money into Chevron and Verizon. I’ll confess to knowing less about Berkshire Hathaway than about the Mets, or even the Yankees, but I have two reactions. I’ve read in the financial press that AAPL is by far his largest position, so the sale may just be housekeeping. What’s more interesting to me is where the proceeds went. Both VZ and CVX have been severe market laggards, have pedestrian prospects, and sport 4.5%+ dividend yields. Their biggest virtue, it seems to me, is that they probably won’t go down a lot in a stormy market. True, I think the world has long since passed Buffett by as an innovative company-level analyst. But he has an incredible information network through the US-centric businesses Berkshire owns. As a strategist, one’s first question should be whether we’re in an up market or a down one. Buffett’s answer is that an incipient return to domestic economic growth is going to mean interest rate increases–implying sideways would be a great outcome for stocks. If so, it would be good to take in some sail and to have some ballast in the bottom of the boat.