War of the Worlds

Tim and Brian walk through the five key aspects of how we select funds/managers for portfolios here at TEN Capital.

FIVE THINGS YOU SHOULD KNOW

1. Equity Markets – fell in this shortened trading week with U.S. stocks (S&P 500) down -0.66% while international stocks (EAFE) fell -0.08%

2. Fixed Income Markets – also declined with investment grade bonds (AGG) down -0.63% while high yield bonds (JNK) fell -0.31%

3. Nationwide Freeze – First and foremost we want to send our thoughts out to everyone affected by the freezing conditions that have caused power outages across the country, most notably in Texas where millions of residents have gone up to 4 days without power amid temperatures as low as -10 degrees. The unprecedented cold even caused some oil reserves to freeze, forcing almost 40% of production to go offline for the time-being. A forecast of warmer weather heading into the weekend is providing hope that the worst of the cold storm is behind us.

4. Vaccine Rollout Update – President Biden stated this week in a town hall event that he invoked the Defense Production Act (DPA) in order to expedite the vaccine rollouts by Modern and Pfizer. The DPA allows the government to nationalize commercial production in times of emergency. As a result, both Moderna and Pfizer have committed to selling more doses to the U.S. at a faster pace than previously planned, with the CEO of Pfizer claiming they are on track to distribute 200 million doses by the end of May which would place them 2 months ahead of schedule.

Key Insight – [VIDEO] Tim and Brian walk through the five key aspects of how we select funds/managers for portfolios here at TEN Capital. [ARTICLE] This week we walk you through the tensions competing for the market’s future direction in order to bring some clarity to many of the stories you may be hearing in the press whether about interest rates, rampant speculation or overbought parts of the stock market.

INSIGHTS for INVESTORS

Intro

Markets of all types have become endlessly fascinating of late with countless extremes developing and resulting in a tug-of-war we haven’t seen for quite a while. Whether it’s inflation vs. a dovish Fed, bond yields vs. the stock market or leveraged speculators vs. long-forgotten blue-chip stocks the stage is set for a reckoning.This “war of the worlds” doesn’t need to be feared as today, as much as any time in a long time, one’s ability to profit from a disciplined and historically proven approach seems at hand.

That said, this week I hope to walk you through these tensions competing for the market’s future direction in order to bring some clarity to many of the stories you may be hearing in the press.

Where are we at today?

For all the prognostications, and various narratives, the reality is that the majority of data continues to signal that both economic growth and core inflation continue to rise. Despite the small pullbacks this week, such a set up bodes well for risk assets (i.e., stocks) over the intermediate term.
This week’s key data points included retail sales which blew away expectations coming in +5.3% (+6.1 if you exclude auto and gas sales), and inflation data in the form of the producer price index that came in pretty hot at +1.3% vs. expectations of +0.4%.

Why would such data lead to a pause in global stock markets? Simply, there is some concern that such data may lessen the amount of fiscal stimulus contemplated by D.C. and lead the Fed to tighten monetary policy sooner than previously expected. We think the chances of either are very low this year, and therefore this week’s “weakness” is likely more opportunity than threat.

What are the potential threats to be watching for?

A. Interest Rates

Analysts Tom Essaye summarized the current potential threats to be watching for well, stating “what I am saying is that over the past few weeks, the number of potential catalysts for a sudden, disorderly rise in yields that hits stocks has risen and now includes 1) Massive looming stimulus, 2) The Fed disavowing any risks of its current policies, 3) Rising inflation expectations and input costs and 4) Rising global yields. So far, all these ingredients have come together to push stocks higher and now, it appears, yields higher. They don’t mean a disorderly rise in yields will happen in the short term, but the number of catalysts that could cause it to happen is growing, and we think it’s important to note that loudly and clearly.”Why is this important?
With the Fed’s tremendously easy monetary policies and unprecedented bond purchases stocks and bonds have posted tremendous gains simultaneously despite their historically low correlation (i.e. they shouldn’t act the same with stocks, a risk on asset, and bonds, a risk off asset). The reversal of Fed intervention and/or a continued spike in yields runs the risk of unwinding both trades and liquidity and easy lending opportunities dry up.
With many investors almost exclusively allocated within the asset class of US stocks and bonds this could become a real issue within many portfolios lacking proper diversification.

B. Dangerous Levels of Speculation

Commentator Lance Roberts highlighted the extreme sentiment and risk-taking noting, “The graph below shows investors' recent preference for risk. Relatively safe S&P volumes sit near four-year lows, while much riskier options and penny stock volumes are multiples of prior norms.”

In short, people are pouring into the “junkiest” parts of the market and doing so with lots of leverage. That isn’t healthy and usually is a warning sign, but we believe the more likely effect given the disparate valuations between parts of the market is a somewhat contained decline (albeit ugly for certain stocks and sectors) that leads to a rotation and newfound strength for previously left behind stocks.
Where Might Opportunity Lie?

Find the forgotten “ones.” This of course means in some case investing in things that have not kept up with much of the recent rally but does also include some parts of the tech sector.

Bespoke highlighted the fact that the long-awaited shift to the more value-oriented parts of the market is likely underway pointing out that “During the 6.5 month stretch from 2/19/20 through 9/2 it was the mega-cap stocks that led the rally. While the 'average' stock was down 2.5% during that span, the five largest stocks in the S&P 500 (red bars) were among the best performers averaging a gain of 40.1% and ranking an average of 48 out of 500 in terms of performance.”

They continued by stating that, “Since 9/2, though, performance has changed considerably. While the 'average' stock is up 20.2% during this period, the same five stocks that led the market from 2/19 through 9/2 are barely higher, averaging a gain of 3.1% and ranking an average of 353 out of 500 in terms of performance.”

And for all those claiming that “everyone is in the pool” and consequently there are no catalysts (e.g. buyers) left to push markets higher, Avi Gilburt citing work by Goldman Sachs countered this week with a great chart showing that there are (a) still plenty of potential equity buyers and (b) that what’s more likely stretched (and thus of concern) are the historic “safe havens” of cash and conservative fixed income.

In Summary

Historically, the type of strong breadth and momentum that currently defines equity markets would strongly argue that we are closer to the beginning of a new bull-market, and yet it is equally true that the level of speculation (see the first chart above) is more indicative of the onset of a bear market.
How do we reconcile these?

First and foremost as always, we avoid the pressure to “make a call” and remain steadfast in our discipline and diversification. That said, the intermediate term answer to the question likely lies in the strong indicator found in prior examples of elevated volatility consistently declining (the VIX index is now below 20 for the first time in months). Such a set up usually means more upside for stocks over the next 6-12 months and that continues to be our expectations despite whatever common volatility may occur along the way.

Have a great weekend!

Tim and the team at TEN.