as/when interest rates begin to rise…

Yesterday I was reading a brokerage report that was trying to lay out a conceptual framework for investors to use over the next few years.

The first part of the argument was relatively straightforward: that the key to future gains (my view: as always) is the level and direction of interest rates. That’s not true for stocks because they’re the funny kind of bond that academic finance makes them out to be. Rather, it’s because stocks, bonds and cash are the main kinds of liquid investment available to you and me. We may have a personal preferences that influence our willingness to switch among them. Nevertheless, changes in the price of any will exert an influence on the others.

An illustration–not so realistic, but the general point is still valid:

Let’s say the current return on cash, the riskless asset, is 1%; the return on bonds is 4%; and the return on stocks is 6%. For whatever reason, the return on cash rises to 10%, with expectations that it will remain there. What happens to bonds and stocks?

My answer: both stocks and bonds decline until their anticipated return reaches 10% plus a premium to compensate for the extra risk of holding them. Broadly speaking, bonds are total losers in this process. Why would you hold onto a bond that yields 6% if you can get 4% more from switching to cash? In the case of stocks, there may be offsets because the forces that are causing fixed income yields to rise (e.g., inflation) may also enhance cash flow and/or profit prospects. Even so, it’s a steeply uphill battle to avoid losing money in a rising interest rate environment.

Since rates are now at effectively zero, arguably the only way to go is up. In addition, since the principal cause of current economic weakness, an incompetent administration that has trashed the domestic economy, is in the process of being removed (kicking and screaming), chances are rates may begin to rise as early as next year.

The brokerage report investment solution? …alternative investments, like hedge funds, private equity and real estate.

Personally, I’m skeptical. Here’s why:

—alternative investments tend to be extremely illiquid. So it may be hard, maybe impossible, to reverse the decision

–the only pricing information may come from the promoters of the investment. It’s hard to know how accurate this will be

–there’s only infrequent pricing information. The fact that the promoters’ assessment of long-term prospects hasn’t change does not mean that the investment is still worth what it was in a lower interest rate environment

–except for a few years after the 2000 internet crash, hedge funds have consistently underperformed S&P index funds over the past quarter-century. Yes, there have been a few winners, but there’s no guarantee we’ll stumble into one

–my observation is that the fees to all but the top, top tier of wealthy individuals are high enough to reduce the net returns to pedestrian levels. I recall, for example, a private fund run by famous Hong Kong-based investors that bought mainland Chinese mid-sized growth companies, which was opening itself to new money. I got to see results to date. The results over the prior ten years for non-family investors was about the same as the return on the Hang Seng index. Maybe less, certainly not more

–early in my investing career I studied the small oil and gas companies that created and sold limited partnerships. The partnerships were typically filled with sub-standard drilling prospects and the limited partner got tax breaks but (my observation) nothing much else. One day early on I got up the courage to ask a successful partnership-selling company what the attraction of the product was …because I couldn’t see it. The answer: not the economics, which were bad, but the idea that the holder could hope to impress acquaintances at social gatherings by alluding to his private investment interests.

one week later, a second vaccine

Moderna

Earlier this morning, Moderna announced that its anti-covid vaccine was not only as effective as the Pfizer candidate whose trial results were announced a week ago, but it apparently also doesn’t need the special refrigeration that the Pfizer vaccine requires.

In Asian trading overnight, US stock index futures were all up by about 1%, with NASDAQ slightly ahead of the S&P and the R2000. On the Moderna news, the R2000 spiked up to +2.3% and NASDAQ dipped slightly into the red. This echoes, albeit more mildly, what happened when Pfizer made its announcement.

Two possible trading patterns for this week:

–this week is a somewhat paler echo of last week, with return-to-pre-covid life beneficiaries rallying for a couple of days, followed by a rebound of pandemic beneficiaries on the idea that normality is a long ways away

–a normality rally without much of a pro-pandemic rebound. My guess is that this outcome is less likely. But it would be more significant, because it would imply the market thinks the pro-pandemic rally we’ve seen over the past eight months has passed its best-by date. For me, this would be enough to accelerate my slow motion shift away from pandemic beneficiaries

the election and its aftermath for stocks

My man-in-the-street read of the presidential election results is that the overall numbers are pretty much the same as in Trump’s self-described “landslide” victory over Hillary, but contain a sharp repudiation of Trump himself . Trump’s bizarre behavior since seems to me to be some combination of cognitive decline and the antics of an aging rocker who’s trashing his hotel room in a sad attempt to remain relevant.

As an American, I’m embarrassed. More worrying than Trump himself are the administration and Republican party officials who are abetting him in what the rest of the world regards as an attempted coup. Unfortunately, we the people own the hotel.

As an investor, I’m concerned that the economic damage he continues even now to do will cause the eventual domestic rebound to be shallower and farther in the future than expected. This complicates the calculus for portfolio repositioning. We might, for example, have a strong pro-cyclical rally driven by AI extrapolations of past experience, followed by a selloff as earnings are announced.

For the moment, however, the most important thing is to analyze how this week’s trading plays out.

gold and the Dow: what ties them together

The Dow Jones group of indices were thought up in the late nineteenth century, a time when bloodletting was still a go-to medical treatment and when people got around on horses. Coal was starting to replace wood as a heating fuel and blocks of ice delivered to your door kept food fresh.

Their two main virtue back then: they’re easy to calculate by hand and they were better than nothing. Today, only the Dow Jones Industrial Average, consisting of 30 large-cap stocks and calculated in the same outmoded way, remains in common use. Nowadays, as I’ve written before, the Dow’s chief value is that it’s a sure-fire alarm bell that the user–mostly media commentators–doesn’t have the faintest clue about the stock market.

A similar, more general, cluelessness “tell” is talking about gold as if it were still money outside of places like China or India, where people don’t trust the banking system and where the ability to bury your wealth in the back yard is a key attribute. I’ve written on and off about gold over the years. You can search for more detail, but this post has a reasonable summary of my thoughts.

I bring this up today mostly because Trump’s latest brainstorm is to revive Judy Shelton’s nomination to the board of the Federal Reserve. Contrary to its prior unwillingness to approve her candidacy, the Senate now appears ready to vote in her favor. This, despite her lack of economic training or experience and the hodge-podge of mutually contradictory views she holds–including her crackpot advocacy of a return to the gold standard abandoned a half-century ago.

what to make of this week’s stock market

Lots of stuff has happened in a short period of time. Some of it is medical (vaccine test results), some political (Biden declared the next president; Trump refusing to concede; the world interpreting the latter, rightly or wrongly, as the start of an attempted coup), some economic (the resurgence of the virus, thanks in part to Trump superspreader rallies, forcing renewed business lockdowns; stock market yo-yoing).

Note: if I were a different person, or if I were still living in my hometown of Staten Island, I might not have the same list. But the welter itself would still be there.

Speaking as investors, it’s our job to filter information from noise strictly from an economic point of view.

While I suspect we will one day look back on the election as having spurred substantial economic and social changes in the US, it’s near-term result will be to remove a self-destructive economic illiterate from the White House. It’s not clear, though, how much better off the US will be, other than that–a year too late–we’ll finally admit the pandemic is a problem and try to control it.

But that’s mostly noise for now, I think.

The real information from this week, as I see it, is that it gives us a clue as to what will happen as the coronavirus comes under control and as Trump’s economy-slowing tariff and immigration policies are reversed. In particular:

–when the market senses the start of an economic upturn, stocks that investors have left for dead have an extraordinary resurgence. This is all about the idea that equity holders won’t be wiped out, that chances for survival have gone from zero to, say, 50%. This means a long-dated option on recovery, which is arguably all the stock is at the bottom, is worth a lot more than it was before. Airlines and cruise ships come to mind.

I think economic good news is too far down the road for the kind of rally we saw on Monday and Tuesday to be sustained. But studying those two days will give us an idea of the kinds of stocks that will do well and those that won’t

–former winners become losers, many times violently so, as economic interest shifts. Given the extreme outperformance of what I’ve been calling “capital flight” stocks, the ugliness of Monday/Tuesday losers shouldn’t be surprising. But growth stock investors are by nature optimists, so it’s good to have a reminder. For me, as an example. I’d moved a quarter of my most aggressive portfolio out of cf stocks into consumer discretionary + a Russell 2000 etf. That didn’t stop me from losing double the NASDAQ decline on those two days.

–the bounceback, if that’s what it turns out to be, on Wednesday and today will likely leave some former winners by the wayside. That will likely be another important indicator from Monday/Tuesday. Typically, a rebound during a transitional time like this will exclude the stocks investors, again rightly or wrongly, think are the least likely to prosper in a new, GDP growth-friendlier environment

What’s a little weird about this week is that my experience is that flashes of worry like Monday/Tuesday last longer than two days. So there may be more weakness to come. Still, I think what’s going on is more a minor relative valuation adjustment than a true change of direction.

taking another look

It’s my birthday and I’m doing birthday things today. If I weren’t I’d be starting to work on my portfolio in two ways:

–I’ve got about a 3/4 – 1/4 split between tech-oriented secular growth exposure and (the 1/4) near-term economic growth names, mostly in Consumer Discretionary. I think I should try to increase the latter a bit

–in the secular growth part, I’ve got two tasks:

—-look at the carnage of the past two days and see if I can rearrange the furniture, that is, upgrade what I hold by buying things that have sold off a lot and selling things that have held up;

—-more important, I have to go through the portfolio name by name and ask myself how each company will fare as/when the economy returns to normal. For example, as/when we see an expansion of in-store shopping, what does this mean for online. How is a smaller pie split among, say, Amazon, Shopify, Walmart, Etsy…? I don’t own any of these, but my guess is that none would be stars but they’d rank from best to worst: AMZN, WMT?, SHOP?, ETSY.