Equity Markets recovered at the end of last week in what looked like a classic ‘buy the dips’ bounce as medium and long term investors moved in to take advantage of some deleveraging and forced selling by the short term traders and market makers. In our view the inflation/reflation story remains intact and while that suggests a rotation towards cyclical and ‘value’ stocks, it does not in our opinion mean that the rest of the market is necessarily as ‘expensive’ as the bond economists are proclaiming. Many structural growth stories remain intact, it is the concept stocks popular with retail speculators and highly rated stocks with no cash flow that are most vulnerable here. Meanwhile, Gold seems to be benefitting from some rotation out of crypto and we need to keep a close eye on the $.
Short Term Uncertainties.
The approach of an end to Covid restrictions continues to encounter resistance from the Health apparatchiks unwilling to relinquish power, leaving us in a somewhat quantum state where the vaccines they wish to take credit for are simultaneously saving us all (and so you must all get one) but apparently not able to cope with the ‘new Indian variant’. Or they are. Maybe. Or not. A sort of Schrodinger’s vaccines, both brilliant and useless at the same time. In fact, there is in fact an awful lot of stuff ‘out there’ that contradicts the official line and we have noticed that it is steadily getting past the censor – which is a good thing, as like investment generally we need to have counter narratives to check our decision making groupthink. This recent interview with Dr Peter McCollough on treatment rather than prevention is really worth watching if you have the time.
Isn’t it time we talked out Cure as well as Prevention?
The continued and deliberately engineered uncertainty is upsetting short term traders more than long term investors and we suspect it is the latter who are buying the dips. Otherwise, the biggest short term uncertainty remains about market mechanics and, in particular, the extent of the leverage unwind among options-based retail buyers and the dealers facilitating them. As we discussed last week, the steady drifting away from equity markets by the highly leveraged retail crowd is hitting the ‘narrative stocks’ harder than most – as demonstrated with the behaviour that sees selling on good news/numbers as well as bad. In effect, any volume is meeting selling down of balance sheet positions in these types of stocks. Meanwhile the dealers have been unwinding their long NASDAQ hedges as the call options they have written for retail move further ‘out of the money’. Indeed, the bounce at the end of last week looked like a ‘buy on the dip’ for equities, generally consistent with the two steps forward one step back routine that we discussed previously.
In the May Market Thinking we discussed how April had appeared to be ‘A Reset of the Reset’ as the old momentum winners from the first half of 2020 rallied sharply and heavily outperformed the more recent post-October winners in the value and size space – albeit we suggested that this would not last, since the important reflation/inflation story was still intact. This is duly playing out, and is picked up nicely in an update of our previous chart (The return of Smart Beta) showing the Ratio of the Market Cap weighted S&P500 index to its equal weighted counterpart. After a spike up in April, the chart is heading lower again, ie the mega-caps are under-performing the smaller caps once more. This is consistent with the notion of buying shorter duration assets in an inflationary environment.
Chart 1. Equal Weighted Out-performing again
Medium Term Risks
The narrative explanation for the weakness was centred around inflation, fuelled by the numbers that came out last Tuesday – even though they told us nothing we didn’t really already ‘know’ from commodity markets – and this was enhanced by the bond economist narrative about higher discount rates being bad for equities as well as bonds. They always say this of course, as if equities generally were ever pricing off a bond yield below 1%. In reality, if we were to reverse out a discount rate for the market, an Internal Rate of Return based on cash flow expectations and what discount rate would be required to obtain the current share price, then the number would be much higher.
Chart 2 does exactly this. Based on some (perfectly reasonable) assumptions from Professor Aswath Damodaran at NYU Stern School of Business in terms of expected future cash flows, we can see that the IRR – the implied discount rate that would enable a Discounted Cash Flow model to solve for the current price – for the S&P 500 at the start of 2021 was around 5.65% and the Equity Risk premium – the difference between the IRR and long bonds was 4.72% – not hugely different to the long term period averages. So in other words, it is difficult to argue that current equity prices are only there as a function of low interest rates on bonds.
Chart 2: Implied Discount Rate on US Equities and Equity Risk Premium
Since then, the T Bond rate has risen by around 70bp, while the equity market has risen around 11%., but then so have earnings expectations, indeed more so. We can’t easily revisit the NYU Stern calculations (though we will return to this topic later in the week), but chart 3 shows the forward multiples on a variety of measures for the S&P500 with the Yellow line FY12 est being the current price divided by the rolling 12 months ahead forecast earnings. This has come down from 23 at the start of the year to around 22 now even as prices have gone higher.
Chart 3. Prices have largely tracked earnings expectations
This will of course have increased the ‘pot’ of future earnings to be discounted which would raise the implied IRR and likely leave the Equity Risk Premium close to its long term average. Of course, as with all valuation models, it is very dependent on inputs. If you do expect bond yields to rise to, say, 3% from the current 1.6%, then we would then see an impact and in particular on those ‘long duration’ equities where most of the expected growth is in the more distant future. As such, to hedge against this, it makes sense not to sell the market , but rather to diversify towards shorter duration assets (as we discussed in our March Market Thinking ). We suspect that the long term investors ‘buying the dips’ are doing exactly this; picking up cash flow positive (shorter duration) stocks with exposure to the reflation/inflation up cycle and leaving the speculative concept stocks friendless.
Longer Term Trends
The unwind of the speculation in parts of the tech market is being mirrored in the Crypto world, especially, as we noted last Monday, with the Elon Musk effect on Dogecoin and now Bitcoin and as noted previously we suspect that some hedging of the ‘anti fiat currency’ crowd involves some buying of gold, which appears to have caught a bid. We would also not be surprised if the recent bout of instability in the Middle East hasn’t also attracted demand for ‘portable wealth’. The longer term theme around the blockchain remains incredibly powerful of course and it is interesting to note that the ‘new’ series on Netflix this month, The Startup , was actually originally aired in 2016, when the underlying concept of a crypto currency was completely alien to most people (indeed, this is part of the subplot). Five years later and the only argument is which ‘coin’ will win, the focus being on whether Ethereum is better than Bitcoin, or indeed Dogecoin, which was set up as a joke, but became ‘real’. In fact, we should be alert to the fact that it may be none of them – Digital Sovereign currency is coming fast and central banks are all getting involved, with implications for monetary policy as well as traditional banking. What if your transfer payments from government are all time limited, like airmiles? What if they are linked to the new databases that are being built as we speak that contain your digital ID, name, address, mobile phone, health data and (thanks to PCR tests) your DNA? Naturally there will be no digital security issues with this (!)
As with much thematic investing, it is often easier to identify the likely losers than the likely winners, but, to close on a positive note, we shouldn’t lose sight of the fact that in almost all cases the real winner is the end consumer.
