While there was an initial attempt at Sell in May and Go Away, as far as equities were concerned the selling by leveraged retail traders was largely countered by buying on the dips for quality stocks from longer term investors. Overall markets were relatively flat and subdued, but beneath the surface there was considerable sector and factor rotation. The April spike in momentum and tech stocks, which was more to do with index buying from Quant funds temporarily boosting mega caps, was met in May with ‘sell on the rallies’ rotation into cyclicals and value stocks by the asset allocators as a broad narrative of cyclical growth evolved. The leveraged traders have clearly moved back into their more traditional habitat of commodities and Foreign Exchange (FX) as evidenced by new price highs across the board, but the biggest noise emerged in Crypto Currency markets. Here we saw what looked like a co-ordinated effort by Central banks and Monetary Authorities in May to ‘de-legitamise’ Crypto currencies in favour of their own digital fiat currencies, triggering a sharp sell off in Crypto and likely margin calls across the increasingly frothy retail stock options markets.
We believe valuations are returning to normal as fundamentals ‘catch up’ with prices as demonstrated by our IRR models and would argue for a focus on pricing power rather than inflation in order to identify cyclical winners. Meanwhile a gear shift in US policy generally means tax and the Petro Dollar are two new factors to consider in our thinking.
Short Term Uncertainty
For many months one of the key uncertainties for markets has been the policy around Covid restrictions and while European governments focus on restricting freedom of movement and the UK and HK government seem to be fighting a losing battle against Zero Covid fundamentalists, it looks like the US has moved on. This is important as it ultimately sets the tone for the rest of the west as well as providing real world evidence to counter the worst-case scenarios in the computer models being promoted by the hard-line lockdown proponents. The other two zeros – Zero Interest Rates and Zero Carbon remain intact however, with the June G7 meeting a showcase for the latter in particular at a time when central banks are seemingly as reluctant to give up on QE and ZIRP as politicians are to yield their new found powers of fiscal profligacy. It is the fiscal side that threatens inflation, for even though the cost of money remains extremely low and the availability large, the velocity of circulation of money in the real economy continues to collapse. It is only the financial sector that wants to borrow money it seems.
Meanwhile, new policy initiatives appear to be emerging from the Biden administration, whether it is a toning down of sanctions on Iran or the rhetoric against the Nordstream pipeline, or calls for a co-ordinated level of Corporation tax, these can have meaningful implications for corporate profitability and hence markets.
Internal rates of Return
Against this background it is worth considering some of the (new) charts below. These show our calculations of the Internal Rate of Return for major markets – essentially the discount rate we would need to apply to map expected returns on capital onto the current share price. The model is acknowledged to be relatively ‘quick and dirty’, taking into account market forward earnings estimates as well as book values and return on equity, but in our view is none the worse for that. All models are only as good as their assumptions and the risk of most models is that they tend to be either overly historic or else to involve an unwarranted degree of accuracy and certainty in their forecast components. Moreover, we find that taking spot calculations and comparing them with a long term average tends to ignore re-rating or de-rating, leaving things looking either constantly cheap or constantly expensive.
IRR For SPX
Here we can see that the Internal Rate of Return calculation for the S&P500 index is returning back towards its previous levels as earnings and earnings forecasts recover from the Covid shock. On this basis an IRR of approaching 7% might be considered as still too low (ie market is expensive), but if we look at the following graphs where we have put it in the context of not only a shorter term moving average but also some upper and low bands based on volatility, we can see what appears to be a steady de-rating as markets move sideways while earnings forecasts improve. The key point is that markets can return to ‘fair value’ by moving sideways while fundamentals ‘catch up’ – they don’t ‘need’ to crash.
Markets can move back to fair value by waiting for fundamentals to catch up. They don’t need to ‘crash’
Note also that the patterns are similar for other major markets, indeed similar levels of IRR with the exception perhaps of Asia Pacific, where there appears to be a recent drop in the IRR.
Medium Term Risk
We continue to believe that the key medium-term risk for investors is the reflation/inflation trade, both for real interest rates and for cyclical stock rotation. The question remains open whether it is a long structural inflation or short/medium term cyclical reflation and in our view it is too early to tell, but that does not affect the need for a cyclical tilt in equity portfolios and a continued lack of exposure to bonds. We suspect that a lot of the buy on the dip rotation into the Quality factor that took place in May was money being taken from bond markets. Bond proxies are the new bonds it seems. As to the other main rotation within Equities, cyclical stocks, we need to focus on two concepts when looking at cyclicals, operational leverage and pricing power. For the first, the ability of increased sales to boost profitability off a high fixed cost is often hugely under-estimated by top down models that tend to equate profits and GDP. Take a company on $100 of sales and a 10% margin. A 10% increase in revenue with a zero or only a marginal increase in unit costs can produce a near doubling of profitability. Often this is linked to an increase in pricing power; if the product is in short supply, higher revenue per unit can also appear, boosting margins and (short-term) profitability still further.
We need to think less of headline inflation and more about a pulse of pricing power shifting through the economy
For the second, the key is to work out how sustainable the excess profits actually are, which translates into assessing pricing power. Here, a quick reference to the text book – Porter’s Five Forces – is probably worthwhile. Note that the ‘East’ and ‘West’ components in the diagram are basically about pricing power.
A rapid supply response can have the opposite effect for example, as the operational gearing is reduced by a fall in pricing power. Alternatively, the cyclical stock may find that their own unit input costs are rising while their ability to pass them on is not. Thus we need to think less of inflation and more of the pulse in pricing power through the economy. If and when it gets to the consumer, it is consumer price inflation, otherwise it is margin compression and expansion, meaning you need to be in the right part of the market.
As noted earlier, a new factor in profitability has appeared in the last few weeks however and was officially announced at the start of June, which is the US drive for a global minimum tax rate for corporates. In effect this is designed to get around the ability of large (mainly US) multi-nationals to arrange their tax affairs so as to pay minimal tax and the most obvious ‘casualties’ look to be the big Tech, Pharma and other ‘platform companies’ that have sought to use globalisation as a way to minimise taxes. A big drive behind this of course is the desire to head off the European push back against (US) Big Tech with a Digital Services tax, so in fact this might turn out to be the lesser of two evils for Tech stocks – should it actually happen. The US still needs to sell the plan back home to a, possibly reluctant, House of Representatives.
US tax proposals may actually be seeking a ‘least worst’ case for Tech stocks
It is likely however that concerns over this sort of issue are at least partly behind the weakness of FANG stocks in recent weeks. Indeed, FANG stocks, as proxied by the equal weighted NYFANG index, are off around 20% versus the S&P500 since the peak in February, and are starting to look rather similar to the NASDAQ selloff in 2000, where after an initial 28% sell off relative to the S&P500 during March April 2000, the NASDAQ subsequently under-performed by a further 40% by year end and another 25% from there before the first year anniversary of the peak. In our view this followed the ‘classic’ framework of our three market participants; 1) Initial rapid exit from short term leveraged funds as the narrative changed followed by 2) two or three quarters of strategic asset allocation back to ‘old economy’ stocks 3) Capitulation and selling by longer term buy and hold investors. This is not to say things will be exactly the same, but rather to point out the consistency of behaviours among the different market constituents.
Long Term Trends
One of the sub themes within our Global Thematic Equity Model Portfolio is Clean Energy, a subject that we have discussed previously in that, while the Clean Energy index was the best performing sub theme in 2020 (+135%) it has been the worst this year at -25% (we have been minimum weighted for several months now). In line with the rotation to commodities and the ‘picks and shovels’ approach we discussed as part of our ‘5C’s’ articles last October, it has been the Oil Services that have taken up the running so far in 2021 as Oil companies start to increase demand in response to higher prices. Moreover, as we discussed previously, (A NICE future for Uranium) the announcement at the start of June that Bill Gates and Warren Buffet are to build a new style nuclear reactor in Wyoming signals another policy shift coming from the US – NICE stands for Nuclear Innovation Clean Energy. Clean Energy isn’t just about wind farms and solar panels, Nuclear has a major role to play – and thus so does Uranium.
Another long term policy that should not be overlooked is the need to preserve the PetroDollar. Look at the 5 Forces diagram above and note the ‘North’ and ‘South’ forces; ‘Threat from New entrants or Threat from Substitute Products. While we continue to watch the level of the currency – its trade weighted level is seemingly stuck in a band between 89 and 92 – its role is what matters most to the US. Owning the world’s reserve currency is a massive strategic asset and we suspect that recent softening on energy sanctions – be they Russian Gas to Europe or Iranian Oil to China is a recognition that if you force third parties to trade in other, non dollar, currencies then you increase the threat of substitutes or new entrants and thus crash the petro-dollar system and with it America’s ‘exorbitant privilege‘.
