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.

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