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.
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.