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In this episode Richard Calhoun, CEO of Laidlaw Wealth Management, discusses the risks posed by crowded trades, whether valuation multiples have reached unreasonable levels, whether developments in the energy market, how the fixed income markets might perform with rising inflation expectations, and how investors may consider looking overseas for 2021 returns.
The topics discussed in this episode are: Howard Marks’ dislike for the markets, is it warranted?, How much might the current corporate earnings cycle outperform Wall Street expectations?, Do rising oil prices present a risk?, Will the fixed income market take away the equity market’s holiday punch bowl?, and With the Dollar weakening, is it time for investors to go overseas?
Please tune in for more timely insights.
Hello and welcome to another episode of “A Brighter Future,” Laidlaw & Co’s Podcast Series. I’m Rick Calhoun, CEO of Laidlaw Wealth Management, and once again I am joined by David Garrity, Chief Market Strategist for Laidlaw & Co.
David, I hope you had a nice weekend and you were able to stay warm as a cold front rolled into the Northeast.
Rick, the snowstorm that rolled through on Saturday served as an excellent reminder to press ahead on holiday preparation activities like getting mailing lists together and designing a holiday card for the season that could bring joy to what has been an otherwise dark year. Also, the storm brought a decent snowfall that should help to bring the start of the ski season to the Northeast, we hope.
So, as we get to work shoveling the snow and salting the steps, we are mindful of the need to wrap things up soon for the holidays and to get ready for the year ahead. In this we also remember that our forebears faced the challenges of their time such as the attack on Pearl Harbor 79 years ago today and through their courage, perseverance and not a small bit of good luck managed to bring us to where we stand today. May we today do the same for those dear to us so they may have a brighter future tomorrow.
David, the cold front’s movement did not cool off the markets, as they stayed hot with stocks edging higher last week extending this historic rally into the first week of December.
Despite a notable slowdown in hiring that was revealed in the November jobs report, major indexes closed at record highs and Treasury yields rose, reflecting expectations for additional fiscal stimulus.
The U.S. economy added 245,000 jobs in November, missing estimates amid a spike in COVID-19 infections and renewed restrictions in activity. The unemployment rate declined to 6.7% from 6.9%, but the participation rate also declined, indicating that more people exited the labor force. A potential “silver lining” is that the downshift in job gains could apply pressure to lawmakers to reach an agreement for a new stimulus package before the end of the year.
At the same time though, as Howard Mark’s of the Oakmark Fund said recently, “fear of missing out has taken over from the fear of losing money. If people become ultra-risk-averse, that’s how you get great bargains. Because they’re risk averse, they won’t buy. They sell at low prices. But if people are risk-tolerant and afraid of being out of the market, they buy aggressively, in which case you can’t find any bargains. That’s where we are now. That’s what the Fed engineered by putting rates at zero.”
So, let’s start our discussion there this week, and make this a multi-part question:
- What are your thoughts on Howard Marks comments?
Rick, to me the words of Howard Marks carry a lot of weight as he has been a successful investor over a number of market cycles doing so by buying when prices were low due to financial distress and selling when prices were irrationally exuberant. If Howard Marks is making cautionary remarks it prompts me to look for where there may be crowded trades that may have developed in the market.
Experience shows that when the financial markets demonstrate a high level of consensus, in this case namely that 2021 will be a year of strong economic recovery globally, it is a rare thing for the consensus view to play out in its entirety. Right now, the crowded trades appear to be: short the U.S. dollar versus cyclical developed-market currencies, long copper and long Bitcoin. On the other hand, bullish positions on oil and gold are less crowded, as are overweight emerging-market equities relative to developed ones.
Along with Marks’ comments, last week brought an interesting paper co-authored by Yale economist Robert Shiller (see: https://www.project-syndicate.org/commentary/making-sense-of-soaring-stock-prices-by-robert-j-shiller-et-al-2020-11). Shiller is notable for his analysis of cyclically-adjusted price-earnings (CAPE) ratios which he used to predict the bursting of the “Web 1.0” stock bubble.
Shiller’s suggested tool for handling the gap between the CAPE and interest rates is what he terms the “Excess CAPE Yield” (ECY) which is a spread that expresses CAPE as an earnings yield, rather than a multiple, and then subtracts the 10-year interest rates. According to Shiller, the ECY has been effective in predicting subsequent returns over the following 10 years. The ECY currently suggests that the U.S. market should be in line for average real annual returns of about 5% per year for the next decade.
Bottom line, Rick, as we mark Marks’ words of caution and work to avoid crowded trades, there is good reason based on Shiller’s work to see markets as still being constructively priced for attractive returns and it appears that investing in emerging market equities, oil and gold may be good trades going into 2021.
- Have we returned to a market, as Barron’s referred to this weekend, where “bad news is good news” and where FOMO is driving investment decisions?
Rick, the November jobs report did send a very clear message that served to underscore Fed Chair Powell’s recent testimony before Congress, namely that the U.S. economy needs more fiscal stimulus and soon.
That the balance in the Senate between GOP retaining control happens to lie in the outcome of the January 5th run-off election for two Senate seats in Georgia is serving to concentrate Majority Leader McConnell’s mind quite wonderfully around the idea of pushing for a fiscal stimulus vote this week.
Failure to do so will give the Democrats a clear message to campaign on which would be that the GOP is happy for the U.S. economy to slide back into recession as they focus their time and effort on trying to overthrow the recent presidential election by raising doubts about the integrity of the election system. So, it’s time for Senator McConnell to get to work, and, yes, Rick, we are back in an environment where bad news on the economy is indeed good news for the market.
On the question of whether “fear of missing out” (FOMO) is the order of the day, we can see in the table below the equity market has rallied hard as the election season passed and, most importantly, that news of successful COVID vaccine tests has come out.
|Growth vs. Value: 4Q 2020 Performance|
|October||Nov & Dec|
|Index||Change %||Change %|
|S&P 500 Growth||-2.8%||11.3%|
|S&P 500 Value||-1.8%||16.1%|
|Growth less Value||-0.9%||-4.8%|
|Russell 1000 (R1K)||-2.5%||14.1%|
|Growth less Value||-2.2%||-4.9%|
|Russell 2000 (R2K)||2.0%||23.0%|
|Growth less Value||-2.9%||-5.3%|
Note this record rally has been driven by a rotation into value stocks and small caps as the prospects for economic recovery in 2021 have grown with the view that vaccine distribution will prove sufficient to contain the COVID outbreaks that under the current administration have been unchecked.
So, while it could be termed a FOMO-driven market, my inclination is to see it as one supported by relief that COVID is being contained and that a new team is coming into power, one that will better address the issues of the day and restore a better order to America and its place in the world.
Meanwhile, these market hopes are underpinned by the fact that the corporate earnings recovery from the 2Q 2020 bottom is continuing and has not yet been accurately assessed by Wall Street analysts. As we have said before, Rick, the stock market discounts earnings power 2 quarters out and Wall Street analysts have always underestimated company earnings early in economic recovery.
In the 2010 cycle, the underestimation was -9%. Applying that to the current Street estimate for 2021 S&P 500 earnings of $169/share results in a more likely result of $184/share. This means the S&P 500 is now trading for 20.1x 2021 earnings, a reasonable early-cycle valuation as there is the chance for further cyclical earnings improvements in 2022 and beyond. Still, the multiple is only reasonable as long as companies continue to show better reported earnings with guidance of further improvement to come.
David – I know we are going to be publishing our Laidlaw 5 for 2021 in a few weeks (shameless plug), but I want touch on one of our 2020 Laidlaw 5 topics for a minute – Oil.
Last week we saw oil extend its gains to a nine-month high after OPEC and its allies agreed to increase production more gradually than previously planned. The outcome of the OPEC+ meeting has been welcomed by the media and speculators as a sign of stability. Optimism about oil prices and a global economic recovery has grown, with a multitude of future oil price graphics spreading like wildfire on the internet.
While oil markets are relieved that OPEC+ will continue to cooperate and the group maintains the ability to move markets, some observers are skeptical as the cooperation by members of the group only came after days of dissent. In what I have read, it seems that OPEC+ does not recognize that OECD economies are on life-support, as financial support mechanisms are keeping these countries afloat and in 2021 most of these financial injections or QE mechanisms will stop as debt levels are reaching disastrous levels.
In addition, the markets should realize that the recent deal is nothing more than an effort to present a “success story to the press” and while the cartel will be happy with $50 per barrel, with current market conditions, OPEC itself still doesn’t admit the threat of a re-emerging Iran, of strong Iraqi production, or of the potential lifting of sanctions by President-Elect Biden. The OPEC+ approach seems to be “if you don’t talk about it, it doesn’t exist”.
So, is this good for us as consumers (i.e. cars, travel in planes etc.) and what could we expect at the pump?
Rick, in our view, OPEC+ is whistling past the graveyard as the long-term shift towards electric vehicles is underway, something reflected in the rising valuation of Tesla and other manufacturers, and the near term as you indicate will likely see the return of Iranian supply to the market on the likely move of the incoming administration to relax sanctions in order to encourage compliance with the nuclear accord. A further element that may emerge as countries seek to implement the Paris Accords is the possibility of carbon taxes that would favor renewables over fossil fuels.
That said, the prospects for better economic growth globally in 2021 support higher oil prices, so I consider oil to be a reflation trade something that has been reflected in the commodity’s steady price gains over the past 5 weeks. As for gasoline pricing, the resumption of driving activity will clearly have an effect that will likely result in pump prices being higher at the end of 2021 from where they are now.
Relative to energy stocks, the return of oil prices over $45/barrel will benefit U.S. oil shale producers. As far as the stock market is concerned, 2021 needs companies to produce revenue gains on top of streamlined cost structures in order to drive share price appreciation. A recent FactSet analysis shows that the energy sector at +13.2% expected 2021 revenue growth is the highest of the 11 S&P 500 sectors. With the energy sector having high fixed costs, we expect the incremental revenues realized off the 2021 forecast will have high contribution margins, something to support energy as an attractive 2021 trade.
David, let’s look at the Fixed Income markets for a minute, if the economy is going to gather steam in 2021, like many think it will with the arrival of COVID vaccines, it should lead to a steepening in the yield curve. That steepening is often referred to as a “bear-steepener” trade, as it would be driven by yields on longer-dated bonds moving up at a faster clip than yields on shorter-dated bonds.
The idea that the shorter-dated paper would be slower to run is linked to a strong belief that the Fed won’t be in any hurry to raise the target range for the fed funds rate as the economy recovers.
The Treasury market has been seeing the recovery light so to speak for many months now but it has been more like a night light, though, as opposed to a flood light considering that the 10-yr note yield has been rather deliberate in its attempt to climb back above 1.00%.
While many had suggested the “bear-steepener” trade had gone into hibernation, last week we saw the 2s-10s spread widening to 83 basis points — a three-year high — from 69 basis points at the end of the prior week with the 10-yr note yield pushing up to 0.98%.
With the 10-yr note yield challenging its mid-November high (0.98%), which was the highest level since March, and sitting on the doorstep of the psychological 1.00% level, will the stock market tolerate a jump in long-term rates, especially since lofty equity valuations and multiple expansion have been catalyzed and rationalized on the back of low interest rates?
On a related question, does this force the Fed change to its asset purchase program to incorporate increased purchases of longer-dated paper in a bid to keep rates from moving up too far, too fast on recovery hopes?
Rick, what lies at the core of this discussion are the questions “where is inflation?” and “how soon will short-term rates rise?”. On the first question, based on the inflation breakevens imbedded in 5- and 10-year Treasury Inflation Protected Securities (TIPS) notes both are now higher than they were at the start of 2020. The levels then: 1.72%/1.80% and now: 1.83%/1.89%. Inflation expectations breaking out signal a market belief that the near future will see better economic growth than the very recent past. So, to the second question, this is now beginning to be reflected in Fed Funds Futures as late last week the CME FedWatch tool put a 6.2% chance on a September 2021 rate hike whereas previously it had been 0%. These are elements to consider as driving rates at the long end of the yield curve higher.
As outlined earlier in our discussion, I expect the stock market will be driven higher by the corporate earnings cycle that is unfolding supported by vaccine distribution and fiscal stimulus driving economic recovery. Treasury Secretary nominee Janet Yellen along with the Federal Reserve under Chairman Jerome Powell will likely hold back on tightening monetary policy and fiscal conditions in favor of letting the recovery take hold. Consequently, while we keep a keen eye on the fixed income market and its ability to call time on the equity market, it is not now approaching a point where the holiday punch bowl is likely to be taken away.
David, as we bring another episode of “A Brighter Future” to a close, I want to get your your thoughts on something I know is important to our listeners – The US Dollar.
Last Tuesday, we saw the Dollar Index
drop -0.65% to fresh multi-year lows last seen in April 2018. As you know, I wrote about it on Wednesday AM and as well you had some great insights on what is happening during your recent interview on the TD Ameritrade Network and I thought maybe you could share those with our audience as I am sure many are questioning how many of those US Dollars they’ll be spending during this holiday season.
Rick, the Dollar index depreciation reflects a normal pattern seen in previous economic cycles in which it weakens relative to other currencies. Currency valuation is a function of GDP growth rate and interest rate spreads. Based on the points made in discussing fixed income, the currency markets in our view are pricing in the expectation of further monetary and fiscal easing in the U.S. going into 2021 and possibly extending into 2022. Relative to the global economy, Dollar weakness is beneficial as it in foreign currency terms serves to lower costs on Dollar-priced commodities.
From what we mentioned earlier as a relatively uncrowded trade, investors in 2021 may wish to overweight non-U.S. markets, especially those of developing economies, against a backdrop of Dollar weakness. In terms of S&P 500 sectors with an above average revenue and earnings contribution from non-U.S. sources, technology and energy rank highly, something for investors wishing to remain only invested domestically to consider.