Over the past half year, and accelerating my pace after the election, I’ve been shifting my portfolio away from what I thought of as “capital flight” mode to prepare for a return to post-pandemic normality. Put another way, I’ve shifted about a third of its assets away from tech-oriented multinationals toward consumer-oriented domestic firms. My initial motivation was the yawning valuation discrepancy between the two groups, and the inevitability of a counter-trend rally at some point. But the rocket ship ride the Russell 2000 began in early November urged me to pick up my pace.

Arguably–and if one believes that the new normal will be a duplicate (I almost wrote carbon copy, but who knows any more what that is) of the old (which I don’t)–a third isn’t enough. In any event, however, this is where I am.

I think I’ve done enough to avoid the worst of the damage the former portfolio structure would have undergone so far this year. And at this point I’d like to see more economic and company data before I switch things up again.

What I want to point out today is the almost daily to and fro pattern of current trading. Every day I click the button that sorts my holdings by that day’s performance. Recently, the greens are either virtually all my older holdings or all my reopening stocks; the reds are the other group. As likely as not, the next day the positions have reversed.

What does this mean?

I think the market as a whole is doing what I am–waiting for more information. This could go on for weeks, although I don’t think we’re in the end game of the transition away from what worked last year.

That’s because I don’t think we’re finished with interest rate increases, and we won’t be until there’s a real yield available from fixed income. How so? I can’t believe people will continue to be so crazy as to lend money, even to the government, knowing they’ll get less back after inflation than they lent.

The 10-year Treasury is at 1.67% as I’m writing this. I think we have to get to 1.80%, where it was pre-pandemic, before the equity market sailing gets smoother. Even then, we may not be seeing an adequate real yield.

For anyone who’s involved with a portfolio every day, as I am, there are a few things to do during this sideways movement. One is to consider whether you’re content with the current mix of secular growth and business cycle sensitives in your portfolio. For myself, I’m happy where I am, although I know any move should be toward more business cycle sensitives. A second is to look at the reds and greens for outliers–stocks that you conceive to be secular growth but which always line up with the business cycle sensitives, or the other way around. I’ve just found one of these that I’ve misconceived–and which I somehow have lost money on in an up market since I bought it. Out that one goes. A third is to consider whether you have your biggest weightings in your highest conviction stocks. If not, why not? This relative calm is the perfect time to fix this.

I was reading a strategy piece from JP Morgan the other day. It begins with pictures of eight badly mangled pretzels, illustrating the contortions investors allegedly (and actually, in my view) to avoid thinking about the negative effect rising interest rates have on stocks.

It goes on to say that if long-term interest rates–let’s pick the 10-year Treasury–stays at 2% or below, the stock market will be fine. If, however, they rise to 2.5% (or beyond) and stay there, it’s a whole new ballgame. I agree completely. The iron law of microeconomics is that what determines price is the availability of substitutes. If the yield on bonds basically triples from its opening level this year, the income-seeking part of our brains is going to find that very enticing vs. the 1.5% yield on the S&P 500. So some money is going to shift away from stocks.

What would cause the yield to rise above the 1.8% level that prevailed just pre-pandemic? A booming economy and a shrinking pool of available unemployed workers. JP Morgan offers three arguments that we’re much closer to full employment than I believe we are: small businesses are reporting record numbers of open “hard to fill” positions; there are few job seekers per job opening; and manufacturing delivery times are very stretched. A fourth is that over the past decade the Fed has invariably overestimated inflation and tightened too soon. There’s a fifth, implicit, argument as well: that “bond vigilantes,” aka professional bond portfolio managers, will start the tightening process ahead of the Fed, as they have often done in the past.

I’d add a sixth: one of my bigger faults is that I tend to be too optimistic. So maybe I’m a pretzel twister, too. The employment figures are worrisome. My question is to what degree they’re influenced by the fact of the pandemic, with people either unwilling to take the risk of returning to work and possibly infecting their families or bound by childcare duties while schools are closed. If the pandemic is a reason for worker shortage, as it comes under control not only will the economy blossom but the available labor pool should increase as well.

We’ll see.

The last time the US had a serious inflation problem was in the late 1970s. That’s more than forty years ago. Except for people who have spent considerable time in inflation-prone areas abroad, no one in the US under the age of, say, 55 has had any practical experience with inflation. Perhaps this accounts for much of the unhelpful discussion of the topic on financial tv and in the financial press.

There are always changes in the price of individual things. PS5s, for example, are in short supply, so potential buyers may have to pay a price far above list from a reseller to snag one. But that’s price gouging, not inflation. The copper price is rising. But that’s due in large part to mine development decisions made maybe ten years ago. And copper is a very tiny part of the whole economy. So that’s not inflation, either. There’s a front page story in the Washington Post this weekend about how expensive used cars became last year as affluent city dwellers fled the pandemic for rural areas. Inflation? No. That could just as easily have been about hand sanitizer–except it’s much easier to see the current glut of sanitizer in just about any store.

Inflation is a persistent rise in the level of overall prices.

Two key characteristics:

–in OECD countries, inflation is virtually always a result of wage inflation, caused by government applying too much stimulus to a booming economy (not where we are now), and

–inflation causes a change in consumer behavior as the expectation that prices will continue to rise inexorably takes hold. People and companies begin to hoard everything, either on the the idea that any item will be just that much more expensive tomorrow, and, for companies, that they can generate future profits just from maintaining fat inventories. People also shift their investing away from bonds toward tangible items like real estate or gold or silver or foreign currency, that they see as protecting them against inflation. In extreme cases, people begin to buy anything tangible, like a couple of used cars to put on blocks in the backyard (this actually happened in Brazil), to preserve their purchasing power. Even better, borrow money from a bank to buy the cars and you’ll also benefit from the falling real value of the loan.

Once inflation expectations develop, they’re very hard to eradicate, and can result in a chronic misallocation of resources.

one thing worse–deflation

The only thing worse than runaway inflation is deflation, a persistent decline in the price level. The thing that makes deflation so scary is that while curing runaway inflation is a long and painful process, at least economists know what to do to fix things. Not so for deflation.

the US today

In the ten years between the financial crisis and the pandemic, inflation in the US, measured by the Consumer Price Index (CPI) averaged about 1.6%/year. The ten years before the crisis, inflation had averaged about a percentage point higher, at 2.5%/year. During the more recent post-crisis period, domestic macroeconomists’ main worry has been about how close the US has been to having deflation and the inability of government policy to move the economy farther away from the zero line. That’s despite a very large tax cut and running a relatively stimulative money policy. Yes, the Trump administration’s reprise of the disastrous Tokyo economic policy of the 1990s may have been a factor in this. But while that’s now being gradually reversed, it’s unclear how much damage is still being done. Even if there’s none, however, the possibility of deflation is still front and center for economists. Because of that, it seems to me the last thing the monetary authorities are thinking about is tightening before we see a convincing move in inflation to the upside. To paraphrase Mr. Powell, let’s see inflation get well above 2% and show signs of rising further before we can declare we’re past the deflation danger and can resume normal policy.

Some prominent hedge fund managers (a group that has been steadily underperforming for almost twenty years) have been making headline-catching pronouncements about the threat of hyperinflation (the used-cars-in the-back-yard kind) in the US. It’s hard to see what the basis is for their claims, other than to get press attention and, implicitly, third-party endorsement for their competence as investors. Hyperinflation is pricing rising 10% a week. Powell is talking about letting domestic inflation creep above 2% a year before clamping down.

so, why is the stock market so wobbly at present?

My one-sentence answer is that we’re returning to normal. Pre-pandemic, the 10-year Treasury was yielding 1.80%. The yield fell to 0.52% last August, before gradually rebounding to about 0.9% as the election neared. We were at 1.1% at the Biden inauguration and have been rising slowly, but steadily since.

There appear to have been technical wobbles recently. For one, the Treasury is beginning to raise new debt at longer maturities than during the prior administration, which has put upward pressure on those longer-maturity bonds. It’s also been reported that at the end of the month commercial banks will lose some ability to trade Treasuries, making the banks less eager to buy new government bonds. Those two issues aside, it may also be that at current yields there isn’t an overpowering appetite for longer-maturity Treasuries.

I’m a stock person. I’ve never run a fixed income portfolio. So I don’t know enough about bonds to be sure how important the previous paragraph is. But that may not matter.

The one thing I’m hanging my portfolio hat on: pre-pandemic, the 10-year was yielding 1.8%. I’ve got to think that in an economy returning to normal the first significant milestone is back at 1.8%. We’re yielding 1.64% now vs. 0.93% at the end of last December. So we’re most of the way there already.

I don’t think this is the end of the road for higher yields. Another way of looking at fixed income is that investors presumably require inflation protection + at least some real yield when they buy bonds. If the Fed wants to see inflation at 2% or 2%+ before it steps in to cool things down (and I think the deflation threat argues it will), then the end point for the 10-year may be 2.2% or higher.

My stock-guy assessment is that true normal for the economy could easily be a year away and that the bond market typically doesn’t look that far ahead. So my guess is that we stay at 1.8% for a while. That could be wishful thinking, though. But if that guess is correct, I think we’ll see the stock market continue to sharpen its focus on reopening beneficiaries while moving generally sideways. If rates continue to power higher toward 2%, it seems to me that the overall market will continue to have its current saggy feel but that the rotation toward reopening winners will, if anything, move more quickly.

Treasury yields and stock PEs

A much-too-simple model (but still one worth something) of the relationship between stocks and bonds equates the interest yield on bonds with the earnings yield (1/PE) of stocks. If we take the 10-year as a proxy for bonds, then last summer’s 0.52% yield implied a PE of 192 for the S&P. The 0.93% of last December equates to a PE of 108. The current 1.64% implies a PE of 61. At 1.8%, the implied PE is 56. At 2.5%, it’s 40.

The absolute figures may be nonsensical, but even if so, I think two important points can be made:

—as interest rates rise, PE multiples contract; and

–if 1.8% is really the next stopping place for bond yields, then most of the damage to stocks has already been done. Not all, but most.

A closing thought: according to Wall Street Journal figures, the forward (meaning using calendar year 2021 earnings) PE on the S&P 500 is currently 22.3x. Using trailing 12 months earnings, the PE is 45x. We have to take the 2021 eps figures with a grain of salt, particularly since they are projecting a doubling of earnings. But the numbers illustrate the relative attractiveness of stocks in an environment like the current one: rising rates push PEs down, but rising earnings push stock prices up. Also, if the WSJ numbers turn out to be anywhere near correct, stocks already more than discount likely near-term interest rate rises.

It strikes me that the important topic that the financial press is most clueless about when it comments is inflation. That’s even though inflation is a central financial issue, because of its key role in determining the level of interest rates–and thereby the level of nominal yields on bonds and the PE on the stock market.

the basics

Inflation is a general rise in the price level in an economy. In the US over the past twenty years, prices have risen at about a 2% annual rate, as measured by the Consumer Price Index (CPI). The CPI is constructed in a way that mildly overstates inflation, but that’s more a quibble than anything else for the US. Mild inflation with no acceleration to the upside is the way most advanced economies work today.

The opposite of inflation is deflation, or a general decline in the price level.

worrisome developments

Deflation is generally bad. Think the Great Depression of the 1930s, where unemployment in the US peaked at 25% of the workforce (compared with 10% during the 2008-09 financial crisis). Washington’s tariff wars, restrictive fiscal policy and tight money all made the situation worse. Deflation feeds on itself. As potential buyers realized that prices were falling, they began to postpone purchases. Also, any company that had issued bonds or taken out a bank loan –both fixed rate instruments–found that as sales revenue began to dry up it was increasingly difficult to generate enough cash flow to repay borrowings. Eventually, many firms went bankrupt, deepening the economic slump.

One of the biggest themes of modern macroeconomics has been to figure out how to stop this from happening again.

Inflation can turn into something bad, if it is high and rising. As a result of persistent, excessive government stimulation in the 1970s, the US exited that decade with inflation at 14% and rising. Unemployment, at 7.5%, was expanding as well, as US companies began to direct cash flows to tangible assets, like real estate and mines, to preserve the real value of their assets.

There’s also hyperinflation, which appears to be defined as price level rises of 50% a month, or 130x a year. Think Weimar Germany or South America.

A change in inflationary expectations (Americans currently expect the current 2% or so to continue, I think) is another possible cause for concern. More about that tomorrow.

nominal vs. real

GDP, or GDP growth rates, or interest rates, or stock and bond prices that we encounter in ordinary life are recorded in dollars of the day, or nominal quantities. Economists break these figures into two components: the results of inflation, and the real (meaning ex inflation) quantities.

A two-year Treasury bill, for example, has a nominal yield today of 0.16%. If inflation in 2021 is expected to be +2%, then the real yield on the two-year is -1.84%. In other words, a holder to maturity will lose 3.5% or so of the purchasing power of his money by buying one today and holding to maturity. Similarly, the holder of a 10-year Treasury note, which yields 1.53%, will lose about half a percent of his purchasing power each year.

More tomorrow.

The stock market is the place where the hopes and fears of investors intersect with the objective profit/asset characteristics of publicly traded companies and express themselves though the level of, and movement in, stock prices.

Prices say to me that we’re getting pretty seriously into fear. Maybe not deeply into fear–I’m not yet reluctant to look at stock prices and I’m at about breakeven year-to-date–but still significantly so, given the extent of recent daily stock price drops.

What’s driving this? Why now?

–-rising interest rates. As I’m writing this, the 10-year Treasury note is yielding 1.54%. This compares with 0.5% last August, and 0.92% in early January. This is an expression of the belief that the domestic economy will likely improve to the point where emergency-low interest rates are no longer needed.

What should we consider as the end point for the 10-year? In 2017, the benchmark rate was around 2.4% – 2.5%. During the initial stimulus of the 2018 income tax cuts, the 10-year rose to 2.8% – 2.9%. It peaked at around 3.2%. During 2019, the yield fell steadily to around 1.75% – 1.85%, as the Fed loosened money policy to offset the weakness caused by Trump’s growth-retarding economic policies. Then came the pandemic and the US “it’s a hoax” response, which pushed yields to their August 2020 lows.

It would seem to me, in very simple-minded fashion (which is the best I can do), the first stop for the 10-year yield is a the return to pre-covid levels of around 1.8%. A full return to normal might imply a rise in yield to the previous 2.5%. To do that would likely require the end of covid plus the economy growing at a trend rate of close to 2%. My guess is that condition is a year away.

If I’m right, yields are up by 60bp so far in the “return to normal” adjustment, with another 25 – 30bp to go. So we’re already most of the way there.

—the end of “capital flight.” In its economics, the Trump administration reprised the the strategy Japan has followed, to its detriment, since the early 1990s–anti- workforce growth through immigration plus preserving the industries of the 1970s. …except for Trump it was the domestic industries of the 1950s. Investors sought to protect themselves from the negative consequences of this policy by focusing on secular change beneficiaries and on multinationals, especially those whose stock in trade is intellectual property and which therefore could easily shift operations abroad. Reversal of the relative decline of the Russell 2000 last November signaled the end of the need to pay a premium for this portability.

—perceived end of pandemic and the stay-at-home trade. The US was especially hard hit by the pandemic, with 20% of the world’s deaths from our 4% of the population. The Biden administration has made the pandemic a priority, however. By improving vaccine distribution and obtaining additional production capacity it looks like reopening will happen much earlier than anticipated. This realization has accelerated market rotation away from secular growth names toward business cycle sensitives.

when is enough enough?

The simplest answer is when yields stop rising. At the current pace, the 10-year Treasury will be yielding 1.75% before the end of the month. My guess is that this is probably enough.

For last year’s winning stocks, my sense is that selling is indiscriminate. At some point, the market will begin to distinguish between stocks whose chief/sole attraction is that they’re pandemic beneficiaries and those that will continue to prosper in a post-pandemic world. For the latter group, the primary concern of the market at present is price. Again, my guess is that this won’t change until bond yields are rising but that investors will refocus on long-term growth prospects once we get some fixed income stability.

Remember, this is all guesswork.

In my mind, the two viable approaches to a market like this are:

–to trust to the portfolio you’ve constructed and do nothing, or

–to try to upgrade holdings by adding to stocks that are being excessively hurt, getting the funds either from holdings of broad etfs or from secular growth stocks that are mysteriously relatively unscathed (assuming you have any)