end of the cycle or the beginning?

I was reading a report earlier this morning that asserted a Wall Street consensus is forming the the current “cycle” is ending–that we would see earnings rising and PEs contracting.

What’s strange about this is not the relatively banal description of earnings growth vs. PEs, but the fact that this behavior, which is characteristic of every cyclical upturn, is being called the end of the cycle.

Imagine a Disney-like theme park and resort complex, call it Xland, that’s a stand-alone business and that caters to middle-class families. In good times, workers get year-end bonuses that they use on an expensive week-long good time at the resort. Recession = no bonus = no family trip to Xland. This cyclical change may mean that Xland goes from gigantic profits to breakeven.

But the stock doesn’t go to zero, even though there are zero profits. Many reasons for this. Maybe Xland has a ton of cash on the balance sheet. It certainly has a brand name and the physical assets of the resort itself. The bottom line is, though, that in bad times earnings contract and, in this case, the PE expands to infinity.

As recession ends and good times return, the stock price usually powers ahead in anticipation of the return of earnings. Then earnings begin to come in, the stock gets a second upward push (assuming the earnings are good) …and the PE contracts from infinity to, say, 20x.

So earnings rising and PEs contracting is just the way the market normally works in the beginning of an upturn.

What reports like this should be saying, I think, is that maybe there’s something qualitatively different about investor behavior in a situation like 2020 where normal life is disrupted and where interest rates turn sharply negative in real terms and are effectively zero in nominal terms. Maybe people go a little bit crazy and do stuff they’ll regret when things return to normal. So some investments people happily made last year are going to look pretty dubious in calmer times–the SPAC universe would be a good place to look for this.

The problem with asserting something like this is that there aren’t many examples in the past, similar to 2020, to point to. I can only think of one–Japan in the very late 1980s.

Even this may be looking in the rear view mirror. Many of last year’s darlings, the stay at home stocks, have lost half their value. SPACs are crumbling. Cathie Wood is no longer the media darling of a few months ago; her flagship fund has lost about 40% of its value over the past three months. So there’s already been a substantial shift away from the 2020 mindset.

I think there are two big current issues we as investors have to deal with:

–the lesser of the two is whether enough of the air has already been taken out of last year’s darlings as a group. The safe answer would be “No” but for me, as someone willing to take an above-average level of risk, I think it’s safe enough to go hunting for bargains

–the more important is the course of interest rates, which are still negative in real terms and close to zero in nominal. Unless the world economy has another serious setback, rates aren’t going to go lower. In fact, they’ve already been rising for about nine months. The issue isn’t whether or not they’re going higher. They are. The questions are when, how high and how does that compare with what’s already factored into today’s stock prices.

more tomorrow

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