trying to rotate (ii)

As I wrote last week, I think the market wants to rotate away from the winners of the past 18 months or so.

Two reasons: the outperformance of tech vs. the rest of the market has been so extreme as to make many professionals (me included) worry that something else must get a turn at bat; and there are echoes of the Internet bubble of 1999-2000 in current trading–lots of chaff, to my mind, along with the wheat.

The big question is where to go. In 2000, the rotation within tech–when that sector began to decline–was to the highest quality names. The (more important) rotation away from TMT (Telecom, Media, Tech), as it was called back then, was to traditional value names that had been in the Wall Street doghouse for the better part of a decade–Utilities, Staples and real estate stand out to me, mostly because I mistakenly chose not to own them.

Also: value managers fired in 1998-99 after many years of wretched returns, of necessity formed hedge funds, and then entered (a short, and) immensely lucrative period of outperformance that established their bona fides as savvy operators. They retain much of that aura today despite weak returns for the past decade and a half.

Hence the Wall Street drumbeat, intensified by hedgies, that a return to “value” is the next big move.

I don’t think history will repeat itself, though, for several reasons:

–my overall view is that the 2000-2002 period was the last hurrah for the 1930s Depression-style investing canon (value investing) that stressed the enduring value of balance sheet assets. While price/working capital, price/book or price/cash flow all retain their roles as starting points, the internet era has enabled such rapid change in economic activity that many of the traditional “moats” value investors like to talk about no longer defend against competition the way they once did. In fact, they can be a detriment. The important advice that it’s “better to cannibalize yourself than have someone else do it to you” is extremely difficult to listen to in a traditional company where executives’ minds have atrophied and whose jobs are threatened by change.

–structural change + Trump’s worst-in-the-world pandemic response are all negatives for utilities, oil and gas, commercial real estate, as well as many types of consumer spending, like restaurant meals or going to the movies. So, yes, these stocks are all beaten up, but to my mind they’re not cheap/

–more than this, the inept/ignorant Trump macroeconomic “strategy” has been to: suppress overall growth, discourage domestic tech research, defend/subsidize non-competitive firms with tariffs, while promoting fossil fuel use (a move which stands to render US auto companies even less world-competitive than they are now). Sort of the plan Putin could only dream of for his enemy

The sum of of all this is that while Trump is in office the last place an equity investor would want to have money–except at extremely low valuations–is in traditional companies making things in the US and serving US customers.

Arguably, industrials overall will rally if Trump is defeated in November. It isn’t clear to me that the Democrats have a coherent economic program, however, so such a move may not have legs. And it’s also possible Trump’s tariff bungling has already given a coup de grace to many of these firms.

I’m not a fan of betting on politics, either.

So I think the best course is to still focus on industries of the future, but to broaden out beyond tech. Personally, I already own ETFs that focus of genomics and fintech–two areas I think are important but that I don’t know much about. I’m trying to build up my exposure to the Chinese economy. I’m not willing to buy individual names in Shanghai or Shenzhen, so I’m concentrating on Hong Kong-listed, where I know the financial statements will be reliable, and where information is available in English.

The non-tech place I typically feel most comfortable is Consumer Discretionary. Here the task is to imagine what post-covid life will be like–and how that will differ from pre-covid days.

More in two days.

two common market fallacies

market cap/GDP

I was reading an article on Yahoo Finance the other day that cited what it claimed was a Warren Buffett rule to gauge whether the US stock market is under- or overvalued. The idea is that if the total market cap of US stocks exceeds annual GDP (of the US) then stocks are overvalued. If market cap is less than GDP, stocks are undervalued.

On the surface, this sounds like it might make sense, since it is the US stock market, after all. And the health of the Treasury bond market is tied to the vigor of the US economy. Also, the idea was big in the 1980s, when market cap/GDP was used by Americans and Europeans as a rationale for not becoming involved in the Japanese stock market during a decade-long domestic economy boom there.

Two issues this idea ignores:

–multinational companies. In the case of the US, a good guess is that half the earnings of the S&P 500 come from outside the US. In fact, a very simple but effective way of approaching structuring a portfolio in the US market is to ask whether the US economy will likely do better than the rest of the world in the year ahead or worse. In the first case, the portfolio should overweight domestic-oriented stocks; in the second, internationally-oriented.

–how much of the domestic economy is publicly traded. In the case of the US, big sectors like real estate and housing have little representation. Germany, whose market cap has seldom, if ever, exceeded half of the country’s GDP, is the biggest counterexample for the cap/GDP idea. Two reasons: almost nothing is listed in Germany, and German citizens have historically had little interest in stocks.

For the record, I can’t imagine Buffett thinks this.

strong stock market = strong economy

Typically, this is the case, in my experience. But there are exceptions, like Mexico in the 1980s–and Germany almost always. In today’s US, it’s easy to see, by comparing the global NASDAQ with the US-centric Russell 2000, that stocks are strong in spite of weakness in domestically-oriented issues. In fact, somewhat like Mexico back then, the US market is underpinned by the near-zero interest rates made necessary by our extreme economic weakness.

A side note: over the past three months, the R2000 (+22.7%) has held its own with NASDAQ (+24.5%). Both have far outdistanced the S&P 500 (+17.5%). Why the R2000 strength? Three possible reasons (translation: I don’t know): counter-trend rally; the worst of the pandemic is already baked into R2000 prices; anticipation that Trump will not be reelected. My guess is some combination of the first two. I think it’s too early to be trying to figure out the election, although belief in four more years of Trump dysfunction should translate into shorting the dollar and the R2000.

going back up?

As far as US stock are concerned, I don’t know.

As/when the correction is over, however, it’s very important to look for signs of a leadership change.  At a minimum, one former hot industry/sector typically grows ice cold; at least one former laggard heats up.  Figuring this out and tweaking/reorienting your portfolio can make a big difference in this year’s returns.

why are higher interest rates good for banks?

There are two factors involved:

behavior of bank managements:  To a considerable degree, commercial banks are able to use changes in interest rates to their money-making advantage.  When rates are declining, banks immediately lower the interest they pay for deposits but they keep the rates they charge to borrowers high for as long as they can.

When rates are rising, as is the case in the current economic environment, banks do the opposite.  To the degree they can, and given that most loans are variable-rate that is considerable, they raise rates to borrowers immediately.  But they keep the interest rate they pay for deposits low for as long as they can.

A generation ago, banks had a much greater ability  than they do now to maneuver the interest rate spread.  That’s because money market funds were in their infancy.  There were no junk bonds to serve as substitutes for commercial loans.  There was even a Federal Reserve rule, Regulation Q, that prevented banks from paying interest on checking accounts and put a (low) cap on what they could pay to holders of savings accounts.

Nevertheless, especially as rates are rising, spreads still can widen a lot.

economic circumstances:   bank lending business tends to tail off in recession, since most companies don’t want to take the risk of increasing their debt burden during bad times–even if the potential rewards seem enticing.  The credit quality of existing loans also worsens as demand for capital and consumer goods flags.

The opposite happens during recovery.  The quality of the loan book improves and customers begin to take on new loans.

stock market effects

The market tends to begin to favor banks as soon as it senses that interest rates are about to rise.  Wall Street was helped along this time around when perma-bear bank analyst Mike Mayo turned positive on the group for the first time in ages last summer.

After the anticipatory move, banks have a second leg up when the extent of their actual earnings gains becomes clear.  It seems to me the first move has already come to an end   …but the second is still ahead of us.