Yes, we’re already almost a third through the year. But I’ve found this is a good thing to do no matter when. The goal is to get an insight or two into the economy of, say, six months from now, that will act like Archimedes’ lever. A starting point can be anything, however small, so long as it’s something you’re confident enough in to start to build an investment strategy around. Better if it’s something you don’t think the market realizes yet. At the very least, knowing that your investment plan depends on this lever, you know to continually check to see whether your idea is playing out and/or whether you still believe in it.

Although every year is its own thing and a little different from any other, 2021 is unusually weird.

Fiscal and monetary policy have been exceptionally loose, mostly to offset the pandemic although partly also to offset the drag from Trump’s economic blundering. We can see the purely financial market results of this looseness in sky-high PE multiples, in rampant speculation in SPACs and meme stocks and in ultra-low (not even compensating for inflation) fixed income yields. Current ructions in financial markets are being caused, I think, by investors beginning to factor into prices the idea that we’re past the peak of such stimulus. If so, the only pertinent questions are when, and how quickly, stimulus will be withdrawn.

I think of this as like being in a prime seat in the center of a movie theater and beginning to smell smoke. You know that sooner or later someone is going to yell “Fire!” and that by that time you’d better be much closer to the exit. But it’s such a good movie…

What’s different about today is that we’re at the beginning of a likely upsurge in post-pandemic corporate profits, rather than at the end, which is the usual situation when government stimulus is withdrawn. Its removal has two typical effects: higher interest rates and stock market PE contraction ( and usually on sagging earnings).

Higher rates, to my mind, mark the end of a 40+year trend of lower yields, which hit their low last summer. A reversal (meaning a new trend of rising rates)? Who knows. But higher rates are bad for bonds. PE contraction, similarly, is bad for stocks. But in the current situation, corporate profits are likely to be rising sharply at the same time. Finding areas where the offset of outsized earnings gains is going to be strongest, especially where they will be surprisingly strong, and/or areas where the market has already factored in a worse outcome than is likely–these are all places to look for stocks likely to outperform.

More tomorrow.

I’m increasingly coming to believe that the growth/value distinction commonly used by market pundits is no longer relevant in today’s stock market. I don’t think that’s particularly surprising. The US economy has changed a lot over the ninety years since value investing was a novelty and the tenets of growth investing hadn’t yet been formulated. In addition, as in any other area, professional money managers study each other very carefully and quickly add successful techniques to their repertoires. So applying them becomes a sine qua for simply continuing to be in the game rather than a differentiator between winners and also-rans.

To my mind, the biggest investment issues for us in 2021 are:

interest rates: the 10-year Treasury note was yielding around 1.9% in late 2019. Yields fell a bit to around 1.8% in 1Q20, as the first worries about the pandemic surfaced. A reasonable guess (actually, my guess) is that yields will return to the pre-pandemic level as reopening gathers steam. So far in 2021 we’ve moved from 0.9% to 1.75%. We’re at 1.7% now. In my view, rates are much more likely to go higher than lower. That’s not good for stocks in general as/when that happens, since one of the big alternatives, fixed income, becomes more attractive. Meme stocks and associated options, SPACs–the most speculative end of the market–would be most vulnerable. On the other hand, this is not the unadulterated negative it would be if rising rates were happening at the end of an economic upturn.

income taxes: Trump’s reduction of the top corporate Federal tax rate from 35% to 21% produced a 25% one-time jump in S&P 500 profits, all of which, I think, was discounted in 2017. It sounds like Biden will raise the top rate to 25%. This should cause about a 5% fall in after-tax profits. Arguably no big deal, especially during a general profit upturn. Biden, however, also wants to remove sweetheart tax breaks for industries like fossil fuels, something Trump promised but made no attempt to do. If Biden is successful, the profits of companies in affected industries would suffer.

More tomorrow.

This is how the current stock market action is being framed, both in the press and in brokerage strategy reports I’ve been reading lately.

I think this is a reasonable first step at describing what’s going on. It also lines up with the way growth and value indices are constructed. Perhaps just as important in a time of deep political division, it’s anodyne enough not to ruffle anyone’s feathers. It’s also better than nothing. For the same reasons, though, it’s more a starting point than a destination.

the odd construction of growth and value indices

The big index providers, Russell, S&P and the FT, all use variations on the same process.

They take an index that consists of, say, 500 stocks. They use traditional criteria like price to earnings, price to book value, price to cash flow and price to sales, in a formula that ranks the stocks from low to high. They group the 250 (more or less) with the lowest scores (that is, the lowest PE, price/book. price/CF, price/sales combination) together as “value.” The other 250 they label “growth.” They periodically rebalance.

One obvious issue with this approach is that the “growth” stocks are, in effect, a box of leftovers. In a broad enough index, the meme stocks and the SPACs would all be classified as growth. On the other hand, the value category can contain zombie companies that only the most doctrinaire value adherents (e.g., value without a catalyst) would touch–and maybe not even then.

Another is that in today’s world, IT, Communication Services (also very IT-ish) and Consumer Discretionary make up half the S&P and were last year’s best performers. So they’re now basically the growth index. And the value index is everything else.

Does a movement to value mean we should load up on oil and gas, mining, electric utilities and commercial real estate? If so, value is not for me.

More on Monday

I’ve been thinking a lot lately about the rotation now taking place in the US. It’s away from the winners of the past four+ years, by and large multinational firms with strong global growth prospects, toward more domestic-oriented firms with perhaps lesser prospects but much lower valuations. I think three factors are involved:

–Trump is gone. Whatever the opposite of an economic Midas touch is, his serial business failures and the mess of his four years as president suggest Donald Trump has it. During his time in office, the stocks of multinationals, as measured by the Russell 1000 Growth index, rose by 108%, as domestic equity investors sought to move their money as far away from the US economy as possible. In contrast, stocks whose fortunes Trump pledged to champion (and maybe did as well as he was able), as measured by the Russell 1000 Value index, advanced by 15%. The S&P 500, which is roughly 50/50 growth/value, was up by 58% over the same span.

The figures are directionally similar if we measure from the 2018 start of the lower domestic corporate tax regime, supposed to boost the prospects of domestic firms. Those figures are: Russell 1000 Growth = +55%; Russell 1000 Value = –3.5%; S&P 500 =+23%.

Since the 2020 election, when Trump checked out of the Oval Office to concentrate on trying to overturn his defeat, this trend appears to have reversed. The Russell 1000 Value is up 28% vs. a 20% gain for the Russell 1000 Growth. The S&P = +23%.

–The pandemic is coming under medical control. As the “it’s a hoax” narrative fades under the weight of 560,000 US deaths (a third more than all American combatants killed during WWII, and approaching the death toll–Union+ Confederate–of the Civil War), and as more Americans are vaccinated, the country is starting to open up again. Actual evidence of increasing demand (as opposed to anticipation) has begun to buoy retail, restaurant, vacation and entertainment names.

— +108% vs. +15% is a ridiculously large spread. At some point, short-term speculators would have to short the winners and buy the losers purely on the idea that the growth over value trend has gone too far too fast. Even if the longer-term growth trend is still intact, there has to be a period of catch up for the laggards.

One way of approaching this rotation is simply to ignore it, to hold your highest conviction names and take whatever bumps come down the road. It’s virtues are that it’s simple and that it’s not time-consuming.

A second, easier to do in a non-taxable account than a taxable one, is to make your holdings look more like the structure of the S&P 500. Last August, for example, I began to trim my tech holdings in my IRA and replace them with a Russell 2000 etf. I did this mostly on a valuation basis–the idea that nothing grows to the sky. I’ve gradually added reopening names, using a combination of more sales of winners and also some R2000 sales. I’m maybe 60% secular growth, 40% business cycle sensitives now. I’m trying to work out whether I should shift closer to 50/50. My hunch is that I’m not going to move back toward secular growth names, but I’m not 100% sure.

A third, more aggressive, move would be to turn sharply pro-cyclical, to, say, 60% business-cycle, 40% secular growth.

This last doesn’t appeal to me very much, mostly because I don’t have very high conviction that this is the right thing to do. Despite what I’ve been writing during the Trump years, I tend to try to avoid all-or-nothing bets. I can move in the cyclical direction, though, in two ways: by ensuring that I don’t have pure quarantine beneficiaries, and by finding stocks that have a combination of cyclical appeal and reasonable secular growth prospects.

More tomorrow.

One of the fundamental forces portfolio investors should be aware of is the tug of war between concept and valuation. Put a different way, between what growth prospects are for a company and the price we have to pay to own a piece of those prospects in the current market.

This question is important because loong history says that prices are determined as much by the hopes and fears of investors as by the objective characteristics of the company profits/profit growth we’re ultimately buying and selling. These emotions, which often feed on themselves, can vary from euphoria to depression.

To my mind, it’s like being in a sailboat sailing across the Atlantic (the fact that I don’t know anything about sailing doesn’t bother me, or matter here). Weather conditions–sunny skies or hurricane–can make a big difference in how you set your sails.

Warren Buffett recently observed that the ratio of the market cap of the S&P 500 to the current level of US GDP is unusually high–higher in fact than at the peak of the internet bubble of 1999-2000. I interpret this as saying that a gigantic storm is on the horizon. It’s just a question of when and how hard it hits.

According to news reports I’ve read (my quick search hasn’t unearthed a transcript) right after this Elon Musk asked Cathie Wood, owner of ARKInvest, what she thought. Her reply was that GDP underestimates US economic growth and, implicitly, that Buffett doesn’t get this. There’s a certain irony here since Buffett’s claim to a place in the American investor Hall of Fame is his understanding, way ahead of everyone else, that conventional accounting statements understate the value of companies with intangible assets like brand names and superior distribution networks.

As far as I can tell, the link between the market cap/GDP ratio and Buffett comes from a 1999 speech in which he describes it as a powerful indicator.

I encountered the idea for the first time–no Buffett name attached to it–in the mid 1980s, as investors and academics tried to come to grips with the apparent overvaluation of the Tokyo stock market. As an explanation, market cap/GDP only worked if you pretended that Europe didn’t exist. Yes, the Japanese market was trading at~2x GDP while the US traded at, say, .8x–these figures are at least directionally correct. That reinforced the idea, which led to terrible investment decisions for a half-decade, that Japan was expensive while the US was cheap. But during the same period, the German stock market was trading at 0.2X GDP, and going nowhere, despite strong GDP growth. The UK market, on the other hand, had a market cap well in excess of all of Continental Europe combined, even though its economy represented barely a fifth of the EU total. So even in the same economic bloc, UK stocks were crazy expensive while their German counterparts were dirt cheap.

Although the industry studiously ignored EU counterexamples to the simple market cap/GDP theory, it seems to me that both the UK and Germany were particularly instructive. In the case of London, most of the market cap represented foreign profits that derived from the UK’s former colonial empire. In Germany, it was (and remains) a question of investor preference: companies preferred to remain private and get the capital they needed from banks; investors had (have) a much greater desire for fixed income than stocks.

Back to the here and now.

At least half the revenues of the S&P 500 come from abroad. I think a much greater percentage of the revenue growth of the S&P comes from its non-domestic exposure. I suspect the foreign percentages for the NASDAQ are considerably higher still. So, in my view, what was a somewhat useful simplification 35 years ago probably doesn’t have much relevance today. That doesn’t mean stocks are cheap or that a storm isn’t on the way, just that market cap/GDP isn’t a great indicator.

What little I get from Cathie Wood’s response is that she seems to believe that the souls of mature iconic American companies are being eaten by insiders’ financial engineering that prioritizes current profits over future growth. Arguably, this will be exposed during the next economic downturn and that, therefore, such firms will not have the defensive characteristics that their size and (lower) PEs might suggest. Think: Intel.