surviving in a confusing stock market

There’s a certain irony to the fact that while Trump was a terrible disaster for the US economy, having an inept white supremacist as president did make the stock market unusually easy to figure out during his term. And his inability to form a coherent plan of action on anything arguably took some of the edge off his racism. Bet against the US economy/on multinationals, particularly those with little plant and equipment or at least little in the US. During 2020, bet on ultra-low interest rates (the only effective government tool during the pandemic) and on stay-at-home stocks.

Now we’re in the process of cleaning up the mess. I think there’s more going on with the Biden agenda than that, but whatever the causes, we’re in a period of substantial market crosscurrents, without a clear roadmap, at least none that I can see. Some of this is timing, like when interest rates will begin to rise. Some isn’t. That’s about what post-pandemic life will look like and whether we’re safely past our “Reichstag moment.”

What to do?

–the key to stock market success is not to know something about everything. Quite the opposite. It’s about knowing as much as possible more than the consensus about a small number of things that will make up the core of your portfolio. In a time like last year, where just about everything ex the Russell 2000 worked, that’s not so important. But at a time like now, when mistakes the punch a hole in the bottom of the boat are much more likely, it’s crucial.

–look like the index with the rest of the portfolio. This is just another way of putting the previous paragraph. If you hold the S&P 500, you’ll get the S&P 500 return. You make your portfolio look different from the S&P, either by holding stocks not in the S&P or by holding S&P constituents in different proportions from the index, with the idea that these changes will produce better-than-index performance. My preference has always been to make large changes in a small number of areas. Today, having a small number of areas is unusually important, I think, and maybe the “active” (meaning differing from the index) position sizes should be somewhat smaller, as well.

–I don’t think this is a forever thing, but until the economic and market situation is clearer, I think it’s better to deepen our knowledge of a few positions we need to get right rather than maintain a superficial awareness of a lot of names.

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PE multiple compression? ETSY as an example

I should start off by saying that although I think ETSY is an intriguing stock, I don’t know it well and I don’t own it directly (there’s the odd chance that a mutual fund or etf I own holds it, but if so I’m not aware of that).

Why choose ETSY? It’s an e-commerce platform that allows craftspeople and small businesses to sell their wares online. At one time pretty badly managed, it seems to me to be much better run today. Perhaps most important, the other main vehicles for craftspeople to sell their wares–fairs, trade shows, physical stores specializing in craft goods–were all shut down by the pandemic. The BIG question for ETSY: as the world reopens, how much of the phenomenal sales growth the company has had over the past year will ETSY be able to retain? …how much will revert to other outlets as they reopen?

There’s no consensus on this, as analyst estimates for ETSY’s earnings for 2021 and 2022 illustrate:

2020 eps = $2.69

estimates

2021 2022

high $3.55 $5.22

average $3.11 $3.80, based on 13 analysts

low $2.44 $1.25.

1Q21 results are already in. ETSY reported eps of $1.00 vs. $0.10 in 1Q20. In other words, even the high estimate suggests that analysts believe ETSY would do well to have flat comparisons for the rest of the year.

Next year is the interesting one, because of the extremes. The most pessimistic analyst thinks earnings will be cut in half. The most optimistic thinks growth might approach (or even exceed) a 50% gain. The average posits flat for the rest of 2021 and a resumption of earnings expansion at a 20%+ clip next year. If we remove the most pessimistic from the mix, eps growth is closer to +30%. Remove the most optimistic and estimated eps growth is more like +18%.

If we think the pessimist is more likely to be wrong than the optimist (whether this will turn out to be right or not, I have no idea), expected earnings performance will almost certainly put upward pressure on the stock price.

Here’s where interest rates come in.

ETSY is trading at $185 as I’m writing this. That’s about 50x trailing earnings, or about a 20% premium to the market. If we assume the 10-year Treasury rises to 3% by the end of next year, the academic stock/bond equivalence theory says the market multiple will shrink to 33X. A 20% premium to that would be 40x. 40 x $3.80 = $152, a loss of 18% from the current stock price of ETSY.

For ETSY to go up by 10%+ over the coming 18 months would seem to require the most optimistic analyst outlook to be correct.

If we say rates will rise to 2.5%, this translates into a 40 market multiple and a 50x multiple for ETSY, assuming it retains its premium rating. In this scenario, the stock stays flattish, save in the case that the most optimistic analyst proves most accurate.

the grain of salt

I’m using precise numbers in the illustration above. Reality is almost always a lot messier. The general point, however, is important–as/when interest rates begin to rise, that alone will be enough to put downward pressure on stock prices through PE contraction based on the greater attraction of fixed income. If rates rise enough, higher rates will begin to have a negative effect on economic activity (people will save instead of spending), and therefore on corporate earnings growth. A 3% 10-year Treasury probably isn’t high enough for that to happen on a large scale–but it probably is enough to make some investors worry about the possibility.

If I were still working, or if I owned ETSY, I’d want to have a talk with the very pessimistic analyst. Assuming that 2022 estimate isn’t a typo, my guess is that the analyst thinks the company’s recent success is purely pandemic-related, and that customers will go back to patronizing traditional brick-and-mortar outlets for art/craft items. I’d like to hear the reasoning.

more on concept vs. valuation

All successful stock investing is based on the idea that we know more than the consensus. If we look at the stock market as a closed system, there are two aspects to this:

–the concept, i.e., our expectations for a stock we think is priced too low, and

–valuation, today’s price of the stock, which reflects the current (uninformed, we hope) market opinion of its prospects.

Professional investors generally employ one of two approaches to finding undervalued stocks. Growth stock investors seek out companies that they think are expanding earnings faster and/or for longer than the market now realizes. They figure this mistaken analysis by the consensus will become apparent–and the stock will rise–as the company consistently posts surprisingly strong (vs. the consensus view, anyway) results. Value investors, in contrast, look for companies that are hitting rock bottom. They think a target company has valuable assets that a bungling current management is not using to their fullest potential and that some internal (the board of directors, say) or external (a potential acquirer) force will change this–leading to a much higher stock price.

Another way of looking at this is that value investors know more about what they own and less about when change will happen. Growth investors, in contrast, know with certainty when earnings will be reported but less about whether their expectations will be fulfilled or not.

Unfortunately, life isn’t that simple. The stock market isn’t a closed system. Substitute investments, in this case bonds, also play a role.

the question of substitutes

The iron law of microeconomics is that price is determined by the availability of substitutes. In the case of liquid investments, the choices are: stocks, bonds and cash. Because of this, changes in interest rates, which have a direct effect on the latter two, also have an immediate effect on the valuation of the first.

This morning the 10-year Treasury is yielding 1.37%. According to academic finance–in this case, the best thinking we have–we can equate the interest yield on bonds with the earnings yield (1/PE) on stocks. The main difference between the two measures, as I see it, is that interest payments go into the bondholder’s pockets, while the shareholder’s portion of company earnings remains in the control of management.

If we thought that yields would stay at 1.37%, the academic equation would imply a market PE of 70x or so. But we know that Treasury yields are a emergency lows today. Nominal yields in closer to “normal” times, which the stock market is already anticipating, I think, would likely be somewhere between 2.5% (implying a 40X PE on the S&P) and 3.0% (implying 33x) . In a robust recovery, even 3.5% (28x) might be possible. The current PE of the S&P 500, based on trailing earnings, is about 38x. This means that in all but the most tame recovery and yield scenario, the PE multiple on the S&P would be subject to substantial compression.

In a robust economy, the kind that would naturally lead yields higher, idle or unused assets would arguably have a greater value than in a somnolent one. So compression of PEs would likely have little effect on price. Stocks whose attraction is accelerating growth, however, i.e., which are valued on their earnings, would presumably bear the brunt of the market PE multiple compression. At least, they always have in the past. For them, investors have to consider the tradeoff between soaring earnings and rising interest rates.

Tomorrow, ETSY as an example.

senses of “concept”

concept stock

“Concept stock” is a derogatory term used for a stock whose sole merit is that it has a good story about how its future will unfold–and little else. “Story stock” is another way of saying the same thing. WeWork is a good recent example, although a case could likely be made in today’s world for any stock brought public through a SPAC. Sometime a healthy dose of fraud is also involved, but that’s not an absolute requirement.

Usually, the company so named is purported to be a growth stock, meaning one whose profits will grow faster than the market expects and/or for a longer time than the consensus believes. Tesla was one of these when it went public, and probably still is one now.

However, I recently heard a Wall Street analyst describe GM as a company with a long history, good brand name and distribution network and reasonable cash flow, but whose domestic market share has shrunk from half the domestic market fifty years ago to 1/7th (despite serious government protection against foreign competition) and whose core business is about to be disrupted by electric vehicles. His argument for the company’s stock is that if GM doesn’t change its hidebound ways the company will die. Therefore, he concludes, GM will change.

This is the quintessential value stock argument.

There can also be a hybrid case, like MSFT, not a deep-value, asset-rich train wreck, but a growthy company that had (very sub-par) earnings growth. It spent the first decade+ of this century in the doldrums until activists forced inept top management to hand over the reins in 2014. The stock is up 9x since.

In all cases, earnings will eventually trump concept, as reported results establish whether the people proposing the concept whether the dreamers who have proposed the concept are right or wrong.

today’s market: concept vs. earnings

There’s a second sense of concept that’s more relevant for the overall stock market today. we still have the same general opposition of concept vs. earnings. But the current situation is one in which large numbers of publicly-traded companies have had either minimal earnings or large losses, due to the pandemic. Others, in contrast, have received stay-at-home bonanzas. ETSY is a good example. It averaged pre-tax income of about $62 million a year during 2017-19. Over the trailing twelve months, it has taken in $513 million.

It seems logical to figure that earnings for the first group will bounce back as the world reopens. It also seems, to me at least, that we may already have seen peak earnings for the second group, or will see the peak during the current quarterly reporting season. But, I think the market is mostly dealing with concept–if for no other reason than because it’s genuinely difficult in uncertain times like these to accurately forecast earnings.

This makes the next couple of reporting periods very important. They’ll either validate of undermine the market assumptions of future growth that are imbedded in today’s prices.

ETSY is an interesting case in this regard. The stock is trading at 52x earnings. The consensus of the 13 analysts Yahoo lists as following the company is that 2021 earnings will be around $3.10/share vs. $2.69 for 2020. For 2022, the high estimate is $5.22, the average is $3.80 and the low is $1.25. I imagine the high estimate assumes that ETSY has finally been discovered and will continue to gain customers as time goes on. The low estimate seems to figure that competition will emerge (if nowhere else, from reopened physical stores) that will pressure both sales growth and margins. I have no idea which camp is right. My point is that they can’t both be.

more tomorrow

2Q21 earnings: concept, eps growth and the pandemic

the pandemic

In 2Q20, S&P 500 earnings fell by about a third, year on year. Stocks rose nonetheless, mostly because of immense monetary stimulus put in place by the Federal Reserve that drove interest rates effectively to zero. The complete lack of investment allure of zero-yielding fixed income made any stock attractive in comparison.

A second pandemic effect on the market came from the panicked, hide-under-the-bed reaction of the Trump administration to the crisis. This had two stock market effects: interest rates were lower than might have been the case had Trump acted to stem the pandemic; and investors swung their portfolios sharply away from purely domestic names (look at the behavior of the Russell 2000) toward multinationals, in addition to the typical move in a weak economy away from cyclicals toward secular growth stocks. (I think the parallels between Trumpism and 1930s Germany also introduced a significant flight capital element into the market, but my sense is that, while lurking in the background, this is not an important current theme.)

One consequence of all this is simple arithmetic. Compared with the pandemic lows of last year, 2Q21 results will likely be very strong. For company earnings just to get back to the 2Q19 profit level, however, eps have to rise by 50% from last year’s level. To get a better handle on where profits are, many analysts have taken the sensible step of comparing 2Q21 results against pre-pandemic 2Q19. This suggests to me that some otherwise eye-popping results will fail to impress Wall Street.

As the economy recovers (absent a new wave of domestic fascism), Wall Street will presumably have much more enthusiasm for domestic cyclical results than for those from secular-growth multinationals.

Thirdly, at some point–and we’ve already seen one false dawn already–the financial markets will begin to factor in a return of monetary policy to normal. We’ll see this in higher interest rates in the money markets and a consequent contraction in price-earnings multiples for stocks. The importance of the rate rise in March is not so much that it showed how little market influencers know about inflation, but that it’s a dress rehearsal for how the market may react when rates actually begin to return to normal.

more tomorrow