2021 has been surprisingly good for stocks, so far.

It’s not 2020-good, but what could be? Last year was a stew of pandemic-induced economic disaster compounded by Trump’s hide-under-the-bed inability to function in a crisis. The combination triggered a Fed stimulus enormous enough to drive the 10-year Treasury from a 1.88% yield on January 1st to 0.55% during the summer. The stock market response was to rise very sharply and, given Washington’s dysfunction, with a strong emphasis on secular growth names and on multinationals.

The 2020 rally began to shift emphasis in early November, when it became clear that Trump would not be reelected. This realization sent the Russell 2000, which focuses on domestic names–and which had been a significant laggard to that point–on a tear that continues to date.

The year to date performance of the major US indices as I’m writing on Wednesday morning is as follows:

R2000 +16.6%

S&P 500 +15.0%

NASDAQ +12.9%.

Even the ARK Innovation ETF (ARKK), which was up by 158% last year, is up slightly, at +3.2% so far in 2021. Admittedly the ARKK ride has been wild, with the ETF ahead by 25% early on, before plunging to -20% by April and recovering to just above breakeven now.

If the year ended today, no one could reasonably complain about 2021 performance.

issues for the second half

–interest rates. It’s pretty clear that rates aren’t going down from here. The real questions are when they’ll start to rise and by how much. The Fed says it will be leaving the overnight money rate untouched through at least 2022. It will presumably be slowing down its unconventional liquidity injections sooner than that. A strong economy, which on balance would likely be a good thing for stocks, probably means the 10-year Treasury rises from the current 1.50% – 1.60% to 2.00% by yearend and to 2.5% sometime next year. My guess is that this is enough to slow the stock market’s advance but not derail it. This is because many stocks will have the offset of strong earnings growth. Clearly bad for bonds, though.

—inflation. I have a very conventional view. In advanced economies, inflation is a function of wage growth. It’s also a question of creating in consumers’ minds the ( economically bad) conviction that prices are going to continue rising at an accelerating rate, a belief the Fed has been at pains to stamp out over most of the past half-century. So, I think that despite recent press hysteria, inflation isn’t a major problem right now for us as investors.

Deflation, a condition we’re arguably still flirting with, is a far more serious potential risk. It’s a serious issue, as the 1930s demonstrated, because financial/operating leverage become killers when prices are falling. It’s a problem for no other reason than we’ve been living next door to zero for a long while now and the Fed has been trying to create inflation, for years, without success.

–reopening.

I think this is the most important consideration for the stock market. That’s at least partly because I think the was reopening will play out isn’t clear. Two aspects:

–there will likely be a sharp differentiation between stay-at-home stocks whose strength has been mostly a function of the pandemic, and which will likely fade as reopening develops vs. stocks where the pandemic has created an introduction to consumers who will continue to use the goods/services as part of a new normal. Etsy, Zoom and Peloton are prime examples. I’m thinking the first two are faders and the third isn’t …but I really don’t have a high level of conviction. Overall earnings growth momentum, however, will likely be lower than

–I think there’ll also be a similar differentiation among stocks hurt badly by the pandemic between those that bounce back sharply as the economy recovers and those that fail to do so. Overall, I think this is a better area to be prospecting in than in pandemic beneficiaries, but I suspect this will also be a story of haves and have-nots. Walmart, for example, is up by about 4% this quarter, while Target has gained 22%. Yes, TGT has a slightly more affluent demographic, but I think this is more about store location and selecting what the consumer perceives as better value for money. I think this will extend to restaurants, travel and entertainment, as well.

generally speaking…

Historically, the Fed begins to raise rates when the economy is operating at or above its long-term potential and people and companies are starting to act in economically destructive ways. The clear intent is to slow economic activity down. In addition, there’s never just one rate hike; it’s always the first one in a series. Perhaps most unsettling, I don’t think the Fed has ever stopped choking the economy back before triggering a recession. So a rate hike is typically a strong signal to begin to batten down the hatches, in expectation of a recession in a year or so.

Although what I’m about to write will send a shudder down the spine of any experienced equity investor, this time may well be different.

Even if so, however, the first instinct of investors, and AI-driven ones in particular, will doubtless be to run for cover.

present value

If we grant the validity (I don’t think it’s the whole story) of the predominant academic metaphor that stocks are a funny kind of bond, a rise in interest rates has a more direct impact on valuation.

Let’s take the example of a mature company (think: public utilities, consumer staples, autos…). Assume it can grow at, say, a steady 10% per year. (This is a simplification. Nothing, in my view, is recession-proof.)

The profit growth profile of a company like this over a decade is as follows:

year 1 2 3 4 5 6 7 8 9 10

income 1 1.1 1.21 1.33 1.46 1.61 1.77 1.95 2.14 2.36

The present value of this income stream when rates are at 2% is: 14.34

At 4%, the PV is: 13.03,

with, as you’d expect, most of the difference coming in the years farthest in the future. At a 4% discount rate, the PV is 9% lower than at 2%.

Now a growth stock, which we’ll assume the consensus believes will grow at a steady 20%/year. The profile:

year 1 2 3 4 5 6 7 8 9 10

income 1 1.20 1.44 1.73 2. 07 2.49 2.99 3.58 4.30 5.16

PV, at 2%: 23.27.

PV, at 4%: 20.93. At 4%, the PV is 12% lower than at 2%.

For an assumed 30% grower, the shrinkage in PV is much more severe as rates rise.

Two conclusions:

–rising rates are bad for all stocks, and

—the farther in the future the earnings are that are being priced into today’s stock value, the worse the negative effect of rising rates on the price will be.

not the whole story

The difference between the stocks that a value investor holds and those in a growth investor’s portfolio isn’t just that the former have slow-growing earnings and the latter fast-growing. While this may turn out to be true, it’s not the rationale for owning them in either case.

For the growth stock investor, the motivation for owning a stock is the belief that the underlying company is actually growing at a faster rate than the consensus understands and/or that superior growth will continue for longer than the consensus expects.

A typical situation is one where today’s price indicates the market thinks a firm will grow at, say, a 20% rate for five years, before tapering back to 10% growth over the following half-decade. This, in itself, isn’t that interesting. What is interesting, however, is when the growth investor’s own analysis indicates company profits are really expanding at a 35%+ annual rate, with no end in sight. In addition, the best growth stories are of companies capable of reinventing themselves. Classic examples: Apple going from near-death to being the iPod company to the iPhone to the ecosystem; Amazon going from online books to online merchandise for others to cloud services to Kindle, Audible, Prime…

how higher rates may work out

My picture is that there may well be a knee jerk reaction to interest rate rises when they happen. Stocks as a class would decline, although not as much as bonds. Growth stocks, the bulk of whose earnings are perceived to be farther in the future than for the stock market as a whole, would likely fare worse than others. Stocks already left for dead by Wall Street might not decline at all.

The initial emotion-driven selloff would likely be followed by a reassessment, in which growth names would begin to recover. If nothing else, earnings reports would indicate both that sellers had overestimated the damage that normalization of rates would cause and that Wall Street had been chronically underestimating the earning power of the best growth names.

present value

Present value is the worth today of a promised payment that will be made in the future.

There are, of course, lots of risks in any contract like this–the borrower might go in to bankruptcy, or simply refuse to pay… Let’s take the case of a Treasury security, where, in theory anyway, none of the typical commercial risks apply. To make this simpler, we’ll assume that the security we hold is a Treasury principal strip. This is a zero-coupon instrument, that is, one it makes no interest payments. It consists of a lump sum payment of the face value of $1000 at maturity, which we’ll say is five years hence.

If we were buying today, what should we pay, given that interest rates–what we’ll use to discount the future $1000 back to today’s value, are, let’s say, 2%? The answer is

1000/ (1.02)(1.02)(1.02)(1.02)(1.02), or $905.73.

Suppose rates rise to 4% immediately after we buy. What is our security worth now? The new present value is 1000/(1.04)(1.04)(1.04)(1.04)(1.04), or $821.93. If rates rise to 6%, the value would be $747.26.

Were rates to fall to 1% instead, the value would jump to slightly more than $951.

Three points:

–this is the simplest and most volatile case. There are no periodic interest payments, which tend to act as stabilizers of the security’s value

–the US government is assumed to be a totally creditworthy borrower, something that hasn’t always been true (think: the Carter administration issue of D-mark and Swiss franc bonds), and

–we’re not taking into account possible effects the business cycle might have on valuation, a factor that’s in theory not relevant for Treasuries but something that could have a significant impact on some corporate bonds (think: junk).

duration

“Duration” is the name for a family of related concepts, the first of which was introduced by Frederick Macaulay. They all use a weighted average of the present values of the cash flows from a bond–interest payments and return of principal–as a way of assessing its sensitivity to changes in interest rates. The basic result is a more muted version of the Treasury strip behavior illustrated above: the farther in the future the preponderance of the cash flows (i.e., the closer it is to a zero-coupon bond), the more the bond moves down as interest rates rise and rises as rates fall.

stocks vs. bonds

The main thrust of the academic financial theory of stocks, as I see it anyway, is to describe them as a peculiar type of bond. This idea has the advantages of simplicity and of piggybacking on the well-developed, present value-based structure of bond analysis and applying it to equities. It also has the disadvantage of not working particularly well, and of functioning increasingly less well as time has passed.

It did work well in the 1950s, when it was developed. The dominant publicly-listed firms back then were ATT, the big integrated oils, miners, steels, automakers, chemicals, stores like Sears and Woolworth… These are the kinds of entities you’d expect to see trading in an emerging market today. Companies had relatively easily forecastable cash flows, dividend yields were high, dividends were perhaps the major investor focus. Also, my sense, which may be incorrect since this is before my time, is that stock market participants back then were mostly very wealthy entities looking for quasi-bonds. Said a different way, lots of value-type stocks were on offer and/because buyers were relatively risk averse and had no stomach for stocks that didn’t look/act like bonds.

Today, we’re in a far different world. Many investors are mainly interested in capital gains, not dividends, for one thing. Many companies (as a result of this change in preference? …or is it vice versa?) are prized for their intellectual property, their brand names, their distribution networks, none of which appear on the balance sheet, but all of which give them a chance at superior future earnings growth. These firms, and their shareholders tend to think of dividend payments as a sign of weakness–that high dividends imply management has no better ideas about how to invest their money–rather than strength.

The academic world really has nothing meaningful to say about large parts of today’s stock market, in my view. There are consequences of the party line that stocks can be reduced to a funny kind of bond, however. If nothing else, this is because no one has come up with a comprehensive, simple-to-teach alternative to the present value discount models.

more tomorrow

El Salvador recently announced that it will accept bitcoin as well as the US dollar as legal tender in that country.

I initially read saw this move through a traditional post-WWII developing economy lens. The strategy, perfected by Japan and subsequently imitated around the world, was to make its primary economic tool a peg of the local currency to the US dollar–and leave everything else to fall out as it may. This move ensured that the export-oriented industries a country pinned its hopes to would not be undermined by currency movements. It also robbed local politicians of the ability to manufacture inflation to paper over operating problems powerful local industrial interests might have. At the same time, however, the peg tended to also usher in a period of general economic austerity–which could be blamed on Washington rather than past mistakes by the local government.

Over more than a half-century this strategy worked spectacularly well in Asia. Not so much in Latin America, though. There, governments have almost always, it seems to me, succumbed to pressure from powerful local interests hurt by economic transition to abandon the dollar peg before tangible positive results could be seen.

..which brings us to El Salvador, about which I’m far from being an expert.

My reading has been that El Salvador has begun to sour on the US dollar and has therefore turned to cryptocurrency as an alternate source of stability. El Salvador wouldn’t be alone in doing so. The Nikkei recently described how Trump’s attempt at violent overthrow of the government, and the continuing large-scale Republican support in Congress of this effort, have deeply shaken foreign confidence in the safety of US Treasury securities. To me, foreigners’ worries seem less about revolution itself than about the economic illiterate who would then be in charge. Their view appears close to what’s expressed in a recent Deadspin article about how Trump destroyed the XFL.

One of my sons has pointed out to me that this may be far too old-school. I may be overthinking the whole thing. One key aspect of El Salvador’s move is that in that country bitcoin is no longer an investment asset subject to capital gains tax. So the decision may have a much simpler motive. El Salvador may just want to become a tax haven for crypto firms.

The S&P 500 gained just under 20% in 2017, the year the large cut in the US corporate tax rate was passed. The new law, which took effect on 1/1/2018, boosted US-sourced earnings by about 21%. In 2018, however, the index lost a little over 6%. That’s because, I think, the stock market began to discount the better earnings prospects as soon at it became clear that the law would pass.

The same will likely happen in the case of a global minimum tax as well. Only this time the effect will be negative, and likely most keenly experienced by companies who have placed the greatest reliance on financial engineering, rather than operations, to boost their profit growth.

It’s also possible that this will be the trigger for investors to once again begin to read a low tax rate as a bad sign for a company, and to adjust the PE multiple down because of this vs. full tax rate-paying competitors as they commonly did a generation ago.

It’s thinkable, as well, that deeper consideration of the information in corporate tax disclosures will lead to a more seismic shift in the assessment of company value of the kind that Warren Buffett caused a generation ago in his stress on the value of intangible assets–intellectual property, brand names, distribution networks…–that the market regards as obvious plusses today, but had ignored until Buffett came along.

There’s already a bit of worry in the air about managements losing touch with the nuts and bolts of the industries they compete in, focusing on propping up current earnings rather than on creating cutting-edge products. Witness investor dismay at the apparent loss of operational competence in once iconic names like Boeing or Intel or ATT. At the very least, in my view, the draining of the ocean of monetary stimulus we are now swimming in will force investors to discriminate more sharply between potential winners and losers as the cost of funding operations begins to rise. As I’ve mentioned before, the only environment remotely like the current one that I’ve experienced is the high-yen, low interest rate environment of Japan in the late 1980s. The early Nineties there were particularly ugly for hidebound traditional zaibatsu/keiretsu firms whose greatest merit was their being in the rising tide of the previous decade. I can imagine a similar changing of the guard happening here.

This would tilt the field of play away from factor investing and toward the more traditional skills of analyzing balance sheets and income statements, and projecting them forward.