a belated update–the stock market in November, plus a couple of days

I’ve just updated my Keeping Score page for November+. A promising start, then a nose dive, as the market continues to adjust to the withdrawal of pandemic-related extraordinary economic stimulus. So far the reality is much less than the pummeling I’ve been imagining the markets are taking. Wall Street is, however, punishing firms whose earnings disappoint with unusual–almost shocking–severity.

omicron

The authorities apparently skipped a couple of letters in the Greek alphabet to get to omicron for the name of the covid strain that’s recently surfaced in South Africa–and is quickly spreading to the rest of the world. Apparently nu wasn’t aesthetically pleasing and xi is also a common name.

It’s not so surprising that on a sleepy day on Wall Street, when most portfolio heads were at home recovering from too much turkey on Thanksgiving, the negative reaction to the possible threat of omicron–speed of transmission + possible resistance to current vaccines–was as large as it turned out to be.

Today, the new news is that omicron symptoms appear to be relatively mild. So markets, in pre-open trading at least, are reversing their Friday swoon.

I think there’s potentially very useful information in last Friday’s trading, especially if coupled with what happens today.

Friday was all about vaccine-makers and stay-at-home stocks. Peloton and Zoom are prime examples of the latter, each up by almost 6% on Friday–and both relatively weak in the pre-market. This pattern makes it easy to compile a list of stocks one might want to own if the world shuts down again, but probably not otherwise.

On the other hand, stocks that declined less than the market on Friday and also outperform today probably deserve a look if they’re not among one’s holdings now.

The converse of that are stocks where the bottom fell out on Friday. These are mostly travel, restaurant and entertainment names, I think. It will be interesting to see how these recover today. My only direct exposure to this area is through DIN, which I regard as a sort of reverse canary in the coal mine. My guess is that any bounce back will be tepid, at best. But let’s see what Mr. Market has to say.

At the very onset of covid early last year, I heard a public health expert speak on Bloomberg. His basic message was the medial consensus: that covid would continue to thrive and mutate into new threats until the whole world is vaccinated. The biggest challenge/threat would be in less developed countries, where the combination of poverty and lack of medical infrastructure (even things like refrigeration) would provide a fertile breeding ground for new variants. What the speaker could not have imagined–or at least was unwilling to put into words–is the political strategy of pandemic/vaccination denial that has emerged in the developed world, spurred on by the Republican party in the US. This is a human tragedy but probably means continuing trading opportunities in covid-related stocks.

yearend housecleaning

Monday and Tuesday were really ugly.

We’re maybe three weeks ahead of the mid-December exodus of professional money managers from their offices to wherever they’re going to spend the holidays. So right now is the last chance they have to tune their portfolios before leaving. This tweaking–for some, major surgery may be a more apt description–has two purposes:

–to set the portfolio up for success in 2022, and/or

–to try to add some extra short-term oomph for 2021 (usually a pretty stupid move) to steer the portfolio either away from the bottom of the pile or into the absolute top.

In all likelihood, 2022 will shape up to be very different from 2021, in my view. That’s because, rather than adding extra economic stimulus, world governments will be stating to withdraw it. In its simplest terms, this means interest rates (and bond yields) will begin to rise. The big uncertainty for next year is not whether rates will rise but how soon and by how much.

Two consequences for the stock market:

–investors will put more weight on valuation of a stock rather than relying mostly on its conceptual story, and

–cyclical recovery stocks, particularly as/when current shortages begin to abate, will likely give secular growth names a run for their money for the first time since 2019.

I have no idea what the trigger for the current selling was. It might have been AI concluding that this year’s stars had risen too far. Or it could have been a large institutional investor having a wretched year deciding to fundamentally revamp holdings.

what to do

A time like this is a good opportunity to see whether your view of the way the market is going can hold up during stress.

For example, if you think, as I have for a while, that stay-at-home stocks are no longer attractive, it will be instructive to see how far they fall and how well/poorly they bounce back when the selling pressure declines. For example, even though Peloton (PTON) has been pummeled this year, it’s down this week by about 8% through the early afternoon today vs. a fall of about 2% for the NASDAQ. Shopify (SHOP), on the other hand, is down by 3%. That’s roughly the same as rival AMZN, even though SHOP has been a much better performer ytd. ROBLOX (RBLX), which has been on a tear since reporting 3Q21 earnings (don’t ask me why, since 1Q and 2Q earnings were also just as good) is off by about 7% since last Friday. On the other hand, it was up by 60%+ mtd through Friday and is up by almost 9% as I’m writing this.

Another thing to do is bargain hunt.

Maybe the most important thing is to try not to mess up a good portfolio by making ill thought out moves.

shifting stock market winds

what I see

In mid-February of this year, the ARK funds, emblematic of the swing-for-the-fences school of investing and already epic winners in 2020, were all wildly ahead of the S&P and NASDAQ (I haven’t tried to figure out exact numbers, but the chart I’m eyeballing says 20+ percentage points or so up on the S&P). For the record, I’m an owner of several ARK ETFs and still hold almost all of what I initially bought (but I have switched much of the rest of my portfolio out of ARK-like names).

Then came a considerable period of sharp underperformance, in which ARK lost all those gains and another 15-20 percentage points as well (the ARK Genomics ETF appears to have lost around double that).

As I see it, the largest components of this slide, in descending order, were:

–relative valuation

–hints that the pandemic might be coming under control

–the ARK managers’ unwillingness/inability to play defense.

One might reasonably suggest that I’m mistaken in my third point and that the ARK folks simply misread the lay of the economic landscape. My reply would be that we’re nine months past the peak but there’s no sign I can discern that the ARK group has adjusted its strategy. Ex possibly ARKG, however, the group appears to have stabilized.

Anyway, the important point is that while the US stock market continued to rise, its tone changed dramatically.

since the September downturn

Over the past month or so, stocks seem to me to have progressed beyond the general notion that the worst is behind us to beginning to discount the near-term earnings performance of individual stocks vs. expectations.

In a traditional market there would be an asymmetry between the performance of the stocks of companies reporting positive earnings surprises and those reporting negative surprises. In a bullish market, the rise in a stock’s price after a positive surprise would typically be relatively strong, while the decline after a negative surprise would be relatively subdued. In a market with a bearish tone, the reverse would be the case.

In contrast to tradition, in today’s market, as I see it, the reaction to both positive and negative surprises has been extreme. My guess is that initial reactions are being driven by AI, with human analysts/portfolio managers following the computers’ lead.

My take is that this marks a further step away from the highly concept-driven market that prevailed during the worst of the pandemic. In particular, I read the greater attention being paid to earnings as prompted by recognition that world governments are beginning to withdrew the extraordinary monetary stimulus of the past two years. Put a different way, valuation is starting to count. For us as stock market investors, this means that the only defense against anticipated rising interest rates will be surprisingly good earnings results.

where to from here?

I find it unusually difficult to say. My base case is that the overall stock market moves more or less sideways, with outperformance/underperformance coming mostly from whether individual stocks in the portfolio belong to the positive/negative earning surprise camp.

I apparently don’t think this will be the only game in town, however.

I recently started a small position in Intel, despite the company’s recent announcement that it’s results will be sub-par for a considerable time. In fact, the announcement is the reason I bought some–with the idea that the company’s value resides in its physical assets and its intellectual property rather than in near-term earnings growth. For me, then, INTC is a value stock with a catalyst for change. It’s in the portfolio for defense. I think INTC won’t go down a lot while new management is refocusing the company back to engineering excellence. If so, it’s a hedge against the possibility that my assessment of a flat market proves too optimistic.

My native optimism, which translates into the assumption that the market will be flattish as the Fed tightens, is one risk I see.

the bigger question mark

A bigger imponderable, though, is how fixed income investors will react to the ending of a 40-year bull market in domestic bonds, driven by ever lower interest rates. According to Investment Company Institute figures, despite the enormous bull market in stocks in the US since the 2008-09 financial crisis, domestic investment money flows have by and large been out of stocks and into bonds. What has saved this flight to safety from being a disaster for refugees from stocks, in my view, has been the march of interest rates to zero, which has created capital gains for holders of long bonds.

We’re now at a point, however, where the dividend yield on the S&P is almost equal to the interest yield on the 10-year Treasury note (in fact, the dividend yield has been higher than the interest yield at certain times this year). The earnings yield (i.e., 1/PE) of the S&P–which is the more common measure of equivalence–is about twice the dividend yield on Treasuries.

This relative value situation was common in the first half of the last century. Chalk that up to the Great Depression and the sketchy nature of publicly-traded companies’ financial disclosure back then. I can only remember once in my working career, however, in the depths of the brutal bear market that followed the internet collapse twenty years or so ago, where I’ve seen stocks and bonds with equivalent payouts (instead of stocks having much lower payouts). And that was in the UK, not the US.

Add to this that the last big down period for Treasuries was forty years ago, and I don’t have the faintest inking what holders will do as interest rates begin to rise. Yes, professional bond managers will presumably continue to move as much money as they can into the short end. But will clients be ok with that or will they take their money back? …if the latter, where will they redeploy it? Presumably either into stocks or cash, but who knows what the proportions will be. Could the flows out of bonds and into stocks be large enough to dampen any stock declines?

thinking about Tesla (TSLA) …or it could just as well be AAPL, AMZN or MSFT

One of the bigger mistakes I’ve seen even professional investors make is thinking that you need to have an opinion about everything–and, worse, have to express that opinion in the shape of your portfolio. It’s actually much closer to the opposite–the key to success, in my view, is to have well thought out opinions about a few things where you figure you know more than the consensus and establish large enough overweights to move performance.

There are, however, stocks that have an index weighting that’s large enough that a professional simply can’t ignore them. Microsoft, for example, is the largest member of the S&P 500, making up 6.3% of the index, and is up by 52% ytd. It’s followed by Apple at 6.0% and Amazon at 3.7%, both of which have been clunkers so far in 2021. Next is Tesla at 2.5%.

The most difficult of these to get my arms around is TSLA. It’s up by 40% ytd vs. a gain of 24% for the S&P. According to Yahoo Finance, it has a market cap of $1.2 trillion and trailing-twelve-months’ earnings of $3.06/share, meaning a trailing PE ratio of 403x vs. 29.4 for the S&P. So it has already done well this year (to say nothing of its epic rise from its listing at $4 in 2010) and appears to be mind-bogglingly expensive.

On the other hand, it’s in the growing part of an essential industry, and faces competition that is really, really inept. And it’s the fourth-biggest stock in the S&P.

What to do?

In my personal case, I held the stock for a while and, uncharacteristic for me, tried to trade its periodic ups and downs. That worked pretty well. Ultimately, though, I decided I wasn’t interested enough to do the research I’d need to make a big commitment. So I sold the stock and bought one of the ARK ETFs that had a 10% TSLA weighting–essentially reducing my exposure and farming the work out to a third party. This doesn’t remove the risk–it simply shifts it from betting on Elon Musk to betting on Cathie Wood. Whether that’s an uptick is unclear, although I must think it is.

That option is arguably not the best. More important, it is generally not open to professionals. If I were still managing money for others I’d do one of two things:

–the easier alternative would be to hold an index weighting, that is, make TSLA a 2.5% position in my portfolio, freeing up my time to research other things. That way, my lack of knowledge/conviction wouldn’t affect my performance vs. the S&P no matter what the stock did.

–I could also ask myself what the end game for TSLA is. The idea would be to sketch out what the most important variables are so that I could see in at least a crude way what assumptions were already reflected in today’s stock price. Maybe this would clarify my thoughts.

Here goes:

–the world automobile market is about 80,000,000 units per year

–assume TSLA ultimately achieves a 10% market share (which would be a lot), meaning it sells 8 million vehicles/year

–let’s say the company makes $20,000 per car, implying yearly pretax profits of $16 billion

–at a current market cap of $1.2 trillion, this would be a PE of 75x, before making any allowance for tax, on earnings that are, say, half a decade away

–let’s say that in a mildly higher interest rate environment than today’s a premium PE would be 40-ish, which is around the current PE of MSFT. If so, a 75 multiple would imply that today’s TSLA price already has built in the assumption that the company is going to achieve something like 20% of the world auto market before it’s done. For the stock to go up from here, presumably belief in a better outcome than this would be needed

–TSLA could do this in one of three ways: gain a larger share of the auto market than 20%, develop large renewable energy businesses in an area other than autos or expand in another, less-obvious-today way

My thumbnail sketch suggests TSLA is pretty pricey. It doesn’t have many defensive characteristics that I can see. On the other hand, I could have made the same general argument in January. And it would presumably benefit from another round of capital flight trade like the one that dominated the US stock market in 2019-20. For a professional, then, index for now but make a note to reduce if the overall stock market waters begin to get choppy.