NASDAQ out of the penalty box?

It seems to me that the extensive correction suffered by last year’s stock market winners is coming to an end. Many former darlings have lost a third to a half of their peak values, which I think is enough to puncture the previous wild-eyed enthusiasm.

What happens from here?

Investors sort through the tech rubble, where, it seems to me, the baby has been thrown out with the bathwater. But a more measured approach than in 2020 will likely be taken. That is, a sharper look at business growth prospects, current earnings, possible competition… I don’t think it’s essential to have an exit plan for everything, as it normally is with any growth stock. That’s because I think the current economic and political situation is still too fluid for intelligent end-game planning to happen. But I woke up this morning thinking about this topic seriously for the first time in a while.

more on inflation tomorrow

what market rotation is

Early in my career I was talking with my friend Roy, a brilliant investor, about the cement industry (one of the many industries I covered for a time back then). He said that if a state, say, Florida, announced a public works road-building program, the straightforward way to play it would be through construction companies. Some people would prefer to play this through materials companies, like cement. He would want to own the companies that make cement trucks instead of wither other group. How so? Three reasons: he knew the ins and outs of capital equipment companies; they were only one or two, they were certain to get some benefit; and the market wouldn’t think that far ahead right away, so he’d have time to build a position at favorable prices.

This is one of my favorite market stories. It shows how Roy’s mind works and it illustrates two important principles of successful investing: stick to things where you think you have an edge, rather than chasing the latest fad; and try to outthink the other guy.

The reason I bring it up today is that it also illustrates a typical market rotation, which is a movement from one group of stocks to another that follows a common theme. The thread that ties the rotation together can either have to do with microeconomics, the economics of industries and firms, or macroeconomics, i.e., movements in the overall economy, driven most often by changes in government fiscal or monetary policy.

Let’s start with the simplest case, our public works program.

road-building

When news comes out, investors tend to focus on the names that will be the biggest and most direct beneficiaries. When those have risen in price, the market moves on to the suppliers of the front-line firms. The former go sideways or down (down happens if enough early investors don’t expand their overall positions and fund their new buys with money taken from the first movers) as the suppliers rise. At some point, interest shifts to capital equipment companies and another rotation occurs.

There can be multiple rounds of this rotation if it turns out that the original idea, in this case, the road building program, turns out to expand into something bigger than originally thought.

1979–oil

Another, more complex example: during the 1979 oil shock, when I was cutting my teeth as an oil analyst, the first companies to move up were the small oil wildcatters, who were pure exploration/development companies. Then came the mid-majors, larger companies whose drilling prowess was harder to gauge and which also had refining and marketing operations that were arguably hurt by the oil price rise. Last in line were the gigantic bureaucratic Seven Sisters, like Exxon, Chevron, Royal Dutch/Shell…, which moved only after everything smaller had.

In addition to the rotation by size, there was a second rotation, away from oil producers to the equipment and service suppliers. There was also a third rotation within the oilfield services group, starting with suppliers of everyday supplies like drilling mud and moving on to renters of drilling rigs, then to suppliers of services for new exploration, like seismic, and then to builders of new drilling rigs. Within this last group, there was another rotation that went from makers of small, relatively inexpensive land drilling rigs to makers of huge deep-sea, hostile environment behemoths.

macroeconomics

This is the most comprehensive, and also the most common, of all stock market rotations.

Its simplest form by far stems from the answer to the question of whether domestic growth will be better or worse than conditions in the rest of the world. For US investors, this is because roughly half the earnings of the S&P 500 come from domestic operations, with 25% from Europe, maybe 15% from Asia and 10% from the rest of the world. The 2020 answer, until very late in the year was “domestic = worse,” so the market concentrated on multinationals. The 2021 answer is “domestic = better,” so the market has been rotating to companies with primarily US exposure. As far as I can see, the whole world works this way.

Its more interesting, and complex, form consists in playing the evolution of the business cycle through four well-known phases: recovery, expansion, plateau, recession. Right now, it seems to me the market in the US has already rotated very fully into recovery ideas and is beginning to explore expansion beneficiaries. Of course, the market is also being influenced by the particular circumstances of the current situation, the reopening after the pandemic.

Traditional economic theory argues that industrial recovery precedes consumer recovery. This is what is reflected in most of the world stock markets. In the US, it’s the opposite.

vs. counter-trend rally

This may be partly (mostly?) pedantry, but I think there is a real distinction to be made between a counter-trend rally and a market rotation.

Counter-trend rally is a period in which the performance differential between market leaders and market laggards becomes so wide that short-term traders begin to sell/short the former and buy the latter primarily on valuation grounds. It’s somewhat like the team losing by ten runs getting its turn at bat and then scoring once or twice.

As the name implies, in a counter-trend rally the primary market trend remains unbroken. The key difference between it and a market rotation is that the counter-trend rally is not motivated by the market sensing a change in the economic winds.

A counter-trend rally usually involves sector movements. But a similar thing happens with individual stocks, as well.

An example with sectors:

Over the past three years IT has gained 25% per year; Energy has lost 12% per year. So IT has doubled while Energy has seen a third of its total value disappear. To my mind, with wobbles in OPEC, pressure for ESG and with electric vehicles right around the corner, Energy doesn’t seem to have a lot, long-term, going for it. In contrast, IT is the future. However, Energy is up by 36% year-to-date, while IT has gained just under 3%. A vintage counter-trend rally.

An example with individual stocks:

Two years ago, AMD was a $27 stock and INTC sold for $44. At the end of last year, AMD was $91 and INTC was $49. Both make semiconductor chips; both make CPUs and GPUs. INTC runs its own fabs; AMD is a customer of TSMC. Both have valuable intellectual property and INTC has a large amount of sophisticated plant and equipment.

Operationally, AMD has been running circles around INTC recently. So it’s reasonable that it has outperformed INTC. But AMD more than tripled over an 18-month span in which INTC was up by 11%. Let’s concede that AMD is a better company than INTC and will do better over the long term. But is it 3x better? The market’s answer is no–enthusiasts have gotten carried away. Five months later, AMD now sells for $78 (-14%) and INTC for $56 (+14%).

Trump, the Fed and interest rates today

The Trump economic program seems to me to have had three prongs:

–promote sunset industries through domestic regulation and import restrictions, to satisfy wealthy Republican donors

–to prevent immigration from Asia, Latin America and Africa, and to expel immigrants already here, to appeal to white racist supporters, and

–to contest the rise of China’s economic power.

The first two depressed domestic economic growth all by themselves; the third (the only good idea of the three) did so through trade restrictions whose design was unfortunately on a par with injecting bleach to cure covid.

Trump countered the negative effects of this toxic stew by pressuring the Fed to run an extremely stimulative money policy. That it was indeed toxic can be seen by the steep underperformance of the US-centric Russell 2000 index from the start of 2018 on, as well as its rocket-ship rise from early last November.

This situation did have at least one important, unintended I think, consequence: very cheap money stimulated a lot of job growth, without the inflation economic theory predicted. Employers were compelled by the shrinking unemployment rate to widen their net from the usual suspects to include more minority workers and the chronically unemployed, and to establish better training programs for them. Since 1985, the US has done by far the least of any country in the OECD to help these groups, and, to my eyes, the paltry programs launched were unsuccessful. Here, on the other hand, was something that didn’t cost the government a lot–and actually worked.

My point?

I think both the Biden administration and the Fed have made this lucky accident an important part of their monetary policy planning. To my mind, most Fed statements allude to this. The implication is that rates will stay lower for longer than the consensus expects.

One could frame this hypothesis in another fashion. Years ago, when the runaway inflation from the late 1970s had been subdued and prices were rising at about a 3% annual rate, the Fed decided to continue to push inflation down to the 2% that theorists of the day posited would be the optimal result. What actually happened was that inflation fell below 2% and the best efforts of the Fed couldn’t get inflation to rise. This frightened economists, as it well should have, since less-than-2%-and-we-can’t-get-it-to-go-up-like-we-thought-we-could is very close to deflation and the visions of today’s Japan/1930s US this conjures up. Arguably, then, nipping incipient inflation in the bud is much less desirable than letting it run to, say, 3%–to get us away from scary minus numbers and, if nothing else, to demonstrate that it can be done. If not now, when?

Either way, my bet is that we’re not going to see the 10-year Treasury yield threatening to break above 1.75% due to Fed action. There’s always the possibility that newspaper reading- and finance talk show listening-AI will run amok, but I have no idea how to figure that into my calculations.

end of the cycle or the beginning?

I was reading a report earlier this morning that asserted a Wall Street consensus is forming the the current “cycle” is ending–that we would see earnings rising and PEs contracting.

What’s strange about this is not the relatively banal description of earnings growth vs. PEs, but the fact that this behavior, which is characteristic of every cyclical upturn, is being called the end of the cycle.

Imagine a Disney-like theme park and resort complex, call it Xland, that’s a stand-alone business and that caters to middle-class families. In good times, workers get year-end bonuses that they use on an expensive week-long good time at the resort. Recession = no bonus = no family trip to Xland. This cyclical change may mean that Xland goes from gigantic profits to breakeven.

But the stock doesn’t go to zero, even though there are zero profits. Many reasons for this. Maybe Xland has a ton of cash on the balance sheet. It certainly has a brand name and the physical assets of the resort itself. The bottom line is, though, that in bad times earnings contract and, in this case, the PE expands to infinity.

As recession ends and good times return, the stock price usually powers ahead in anticipation of the return of earnings. Then earnings begin to come in, the stock gets a second upward push (assuming the earnings are good) …and the PE contracts from infinity to, say, 20x.

So earnings rising and PEs contracting is just the way the market normally works in the beginning of an upturn.

What reports like this should be saying, I think, is that maybe there’s something qualitatively different about investor behavior in a situation like 2020 where normal life is disrupted and where interest rates turn sharply negative in real terms and are effectively zero in nominal terms. Maybe people go a little bit crazy and do stuff they’ll regret when things return to normal. So some investments people happily made last year are going to look pretty dubious in calmer times–the SPAC universe would be a good place to look for this.

The problem with asserting something like this is that there aren’t many examples in the past, similar to 2020, to point to. I can only think of one–Japan in the very late 1980s.

Even this may be looking in the rear view mirror. Many of last year’s darlings, the stay at home stocks, have lost half their value. SPACs are crumbling. Cathie Wood is no longer the media darling of a few months ago; her flagship fund has lost about 40% of its value over the past three months. So there’s already been a substantial shift away from the 2020 mindset.

I think there are two big current issues we as investors have to deal with:

–the lesser of the two is whether enough of the air has already been taken out of last year’s darlings as a group. The safe answer would be “No” but for me, as someone willing to take an above-average level of risk, I think it’s safe enough to go hunting for bargains

–the more important is the course of interest rates, which are still negative in real terms and close to zero in nominal. Unless the world economy has another serious setback, rates aren’t going to go lower. In fact, they’ve already been rising for about nine months. The issue isn’t whether or not they’re going higher. They are. The questions are when, how high and how does that compare with what’s already factored into today’s stock prices.

more tomorrow

shortages: semiconductors

The semiconductor story is a bit more complicated.

background

Semiconductor development has always been all about making chips that are smaller, faster and use less energy (or generate less heat).

In the early days, a given company’s engineers designed chips that the firm made in its own fab (factory). By the mid-1990s, the two processes, design and manufacture, began to separate. Two reasons:

–the cost of a fab making state-of-the-art chips has been continually rising as manufacturing technology has become more complex. Today, for example, a cutting edge fab costs about $15 billion. Just as important, it will spew out at least $40 – $50 billion worth of chips a year. Few firms can afford to build one; fewer still have the sales volume to justify doing so alone.

–these factors, the desire of designers to work for themselves rather than in a bureaucratic behemoth, the development of third-party design tools (ARM is the prime example) and the startup of third-party fabs (foundries, TSMC by far the leader) have led to the development of specialized design and manufacturing firms.

–five years ago, Intel was the undisputed chip manufacturing leader, making its own designs, primarily for personal computers and for servers. Today, however, its manufacturing capabilities have fallen behind those of TSMC and its designs behind those of TSMC customer AMD.

–in somewhat similar fashion, there’s no American manufacturing leader in 5G, the latest generation of telecom equipment. The baton has passed to Huawei, which also makes better/cheaper conventional telecom equipment, as well. Huawei does. however, use American-designed chips.

why supply disruption?

The pandemic is the biggest culprit, in two ways. The virus caused the shutdown of chip manufacturing and distribution early last year. At the same time, demand for stay-at-home devices, from PCs to video game consoles to intelligent autos, began to boom.

The collapse of the makeshift Texas electricity grid caused another halt to the manufacture of chips there (a surprisingly large amount).

Also, facing the loss of the next generation telecom market to China, the only counter the Trump administration could come up with was to undermine Huawei by deny Chinese firms access to semiconductors made by US firms or made using US intellectual property, or made on machines that employ US intellectual property.

This action has implications. It reduces today’s effective capacity, since US-linked sources can’t supply China. It also makes the question of where to locate new capacity more problematic–except for TSMC, which has announced a massive expansion program, centered on Taiwan. It may also have kickstarted China’s languishing program to develop its own semiconductor industry. This presumably means eventual global overcapacity, but probably not during any time frame important to stock market investors.