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Synopsis: “A Brighter Future” – Episode 39
In this episode Richard Calhoun, CEO of Laidlaw Wealth Management, discusses whether The Federal Reserve can be thought to have abandoned the concept of moral hazard, the strength of the corporate earnings recovery as shown in the 4Q 2020 earnings season, the growth in ESG portfolios and how this may impact technology companies, and the significance of the current speculative bubble in heavily shorted assets.
The topics discussed in this episode are: Has The Fed abandoned moral hazard?, What are the take-aways from the strong 4Q 2020 earnings season? What are the broader implications of ESG’s rise as a portfolio management framework?, and Does the “Reddit Mob” speculative wave mark the end of the current stock market advance?
Please tune in for more timely insights.
Hello, and welcome to another episode of “A Brighter Future.” I’m Rick Calhoun, CEO of Laidlaw Wealth Management, and I am joined again by David Garrity, Chief Market Strategist for Laidlaw & Co.
David, I hope you are safe and warm as the Northeast is in the middle of a major snow storm, while the market is in a storm of its own.
Rick, turbulence is the watchword here, most certainly. As harsh conditions generally prompt one to batten down the hatches, it is not surprising to see the news last week that hedge funds were reducing their books as the S&P 500 sold off -3.31%. Currently, in line with our “Laidlaw Five” forecast, we expect the volatility to continue until such time as COVID vaccination efforts gain better traction.
David, what a week. We will address GameStop later in the episode, but today being February 1st means we are one month in for the stock market in 2021, but I think this might be a month we’ll be talking about and dealing with all year because this was truly not an ordinary January:
- Georgia had a runoff for both of its Senate seats and Democratic challengers won both races, leaving the Senate split 50-50 between Democrats and Republicans.
- There was an insurrection at the U.S. Capitol that resulted in five deaths.
- The House of Representatives voted to impeach President Trump before he left office for an unprecedented second time.
- Joe Biden was inaugurated the 46th President of the United States of America and Kamala Harris became the first female, first black, and first Asian-American to hold the office of Vice President of the United States.
- A spokesman for China’s defense ministry warned Taiwan that independence means war.
- Fed Chair Powell said he doesn’t see the Fed raising rates anytime soon and that inflation is going to be allowed to run above +2.0% for a time.
- Hot on the heels of Congress passing an additional $900 billion stimulus package, President Biden proposed a $1.9 trillion stimulus package.
- The Russell 2000 gained +5.0% and the S&P 500 energy sector gained +3.7%.
- The 10-year note yield climbed back above 1.00% for the first time since March 2020.
- COVID vaccination efforts got off to a slow start, but gained some momentum as the month progressed. In turn, Johnson & Johnson (JNJ) said its single dose COVID vaccine candidate is 66% effective in preventing COVID, but 85% effective in all regions in protecting against severe COVID cases and provides complete protection against hospitalizations and death.
- And finally, driven by retail interest and a populist movement that gathered momentum on social media, there was an epic short squeeze on heavily shorted stocks — GameStop (GME) chief among them — that reportedly upended a number of hedge funds, commanded the attention of Congress and regulators, and pitted Main Street against Wall Street.
So, given the rather full menu I just ran down, I’d like to start our discussion today on the topic of the Fed.
In your opinion, has this Fed abandoned the idea of “moral hazard?”
I ask this in light of the fact that both the Fed’s statement and Powell’s commentary at the press conference were extremely dovish. In fact, there was zero hint that the FOMC was even contemplating tapering QE, and in fact there were multiple mentions by Powell about expanding QE if necessary. As a result, several reporters asked Powell if he was concerned the Fed’s policies (QE and others) risked creating bubbles and encouraging the types of behaviors that have led to for example the GameStop fiasco.
Rick, moral hazard occurs when an entity has an incentive to increase its exposure to risk because it does not bear the full costs of that risk. The notion of the “Fed Put” has been popular since Federal Reserve Chairman Alan Greenspan lowered interest rates in 1998 to forestall a stock market sell-off after the collapse of hedge fund Long-term Capital Management.
While the “Fed Put” is clearly alive and well given the amount of monetary relief provided by The Fed and other central banks to the global economy since the onset of COVID, it is not fair to say that the idea of moral hazard has been abandoned. Moral hazard generally applies to a situation where an entity does not bear the full burden of the consequences of their own bad decisions.
In the context of the COVID pandemic, it is fair to say no one intentionally went out to catch the disease, it was an exogenous shock that brought the global economy to a crashing halt. However, the Fed must be mindful that while it has succeeded in helping to stabilize the global economy and supported the capital markets, it has also enabled extreme “risk-on” moves in areas of the stock market such as heavily shorted stocks.
David, as we have discussed, there was an ebb and flow in January in which pro-cyclical plays led the way some days and the mega-cap stocks led the way other days.
Small caps did very well for most of the month but faded in the closing stretch. The energy sector ran hot to start the year, but cooled off considerably in the back half of the month as did the financial sector hot start, cold finish.
There wasn’t a lot of consistency throughout the month of January, except for the Federal Reserve, which as we just discussed promised to keep filling the punch bowl and Congress, which continued to squabble about providing more stimulus.
There has though been one consistent thing though, and that’s a solid fourth quarter earnings reporting season. S&P 500 companies are blowing expectations out of the water. I know you are scheduled to be on Bloomberg Radio later this week to discuss this very topic but was hoping maybe you could offer a “sneak peek” into your analysis.
Rick, despite all the aggravation to the stock market since the start of 2021, the baseline that investors need to focus on is the cyclical recovery in corporate profits which continues to outperform expectations.
Along with generally positive developments around COVID vaccines, it is the profit recovery that we credit with keeping stock market losses moderate in January with recovery plays such as the energy sector, small-cap stocks and overseas markets showing positive progress.
|Performance: Year-to-date 2021 – Style, Market Cap & Sector|
|Index||Price Change||vs. S&P 500|
|S&P Health Care||1.4%||2.5%|
|S&P Real Estate||-0.4%||0.7%|
|S&P Communication Services||-0.9%||0.2%|
|S&P Consumer Staples||-5.0%||-3.9%|
|Performance: Year-to-date 2021 – Geographic|
|Index||Price Change||vs. S&P 500|
|– U.S. Dollar Index||0.7%||1.8%|
|MSCI Emerging Markets||3.2%||4.3%|
|MSCI South Korea||2.4%||3.5%|
|MSCI Frontier Markets||2.2%||3.3%|
|MSCI Emerging Mkts ex-China||0.1%||1.2%|
Relative to 4Q 2020 earnings season, roughly 37% of the S&P 500 index companies have reported results and their out-performance of Street expectations continues as they are beating EPS estimates by +13.6%, well above the 5-year average of +6.3%. The 4Q 2020 performance is on track to show the fourth best beat percentage since at least 2008 as 82% of companies have beaten their estimates so far this quarter, close to the record 84% from Q2 and Q3 2020.
Even more surprisingly, 4Q 2020 is now on track to show positive revenue comparisons to 4Q 2019. The current consensus is for +1.7% revenue growth; analysts were looking for flat (+0.1%) when earnings season began. Aggregate S&P company revenues have thus far beaten analysts’ estimates by +3.2%, the highest on record.
Most importantly, this is prompting Wall Street analysts to raise numbers for 1Q 2021, by +3.4%. This is an unusual occurrence as the Street is usually cutting numbers by this point in the current quarter. The critical analysts estimates here are those for 3Q and 4Q 2021, which represent the best Street guesses for normalized post-COVID corporate earnings. These are also grinding higher, up +2.3% since January 8th.
Current estimates for 2H 2021 are $91.42/share, up +14% from 1H 2021’s $79.96.
Annualizing 2H 2021 results in earnings power for the S&P 500 index of $182.84/share, indicating a market multiple of 20.3x which is acceptable if The Fed stays the course in not raising interest rates over the course of 2021.
David, let’s talk about a completely different topic, but one that prior to last week was starting to get a lot of attention and that’s ESG investing which looks at a company’s Environmental, Social, and Governance strategies.
Maybe you can share a bit more with our listener’s what the “ESG movement” means and how this movement, being driven by the likes of BlackRock’s Larry Fink, could have a major impact on their portfolios.
Rick, as we have discussed in prior conversations, the ESG approach to portfolio construction has garnered greater traction as investors across all categories have come to accept that profit maximization no matter the costs is not the best way to run an economy. In this regard, how companies manage all stakeholder constituencies – customers, communities, employees, the environment – is being more clearly seen as setting the benchmark against which company management should be measured.
Interestingly, this shift dovetails with growing concerns across society with the advent of increased calls to examine how technology companies, and most specifically social media companies, have impacted the economy, politics, and, more broadly, society at large. Some have said an invisible coup has been engineered by technology companies as they have created an ecosystem of surveillance capitalism that has for all practical intents and purposes overthrown democracy (see: https://www.nytimes.com/2021/01/29/opinion/sunday/facebook-surveillance-society-technology.html?referringSource=articleShare). This growing awareness could lead to some technology companies being excluded from ESG portfolios.
There is an awareness within the technology sector of the growing importance for companies to distinguish their business models from the “data capture at all costs, data is the new oil” approach. Speaking recently in Brussels at an event marking International Data Privacy Day, Apple CEO Tim Cook said, “If a business is built on misleading users on data exploitation, on choices that are no choices at all, then it does not deserve our praise. It deserves reform. We believe that ethical technology is technology that works for you. It is technology that helps you sleep, not keeps you up. It tells you when you’ve had enough.” (for full article, see: https://www.inc.com/justin-bariso/tim-cook-may-have-just-ended-facebook.html)
As we can see here, Rick, ESG is an approach that will have consequences that are far-reaching not just in terms of how assets are managed, but on the conduct of business as a whole.
David, 2020 may be over, but this past week added to the list of unique market behaviors that started last year. GameStop and “short squeeze” became household names overnight, as the stock skyrocketed and the narrative around small day traders versus massive hedge funds captured nearly all the attention in recent days.
If history is a guide, GameStop will not maintain its grip on the headlines, repeat its parabolic share-price ascent or remain the driving force behind overall stock-market moves. But as we bring this week’s episode to a close, let me ask if you think it represents a broader condition of the market, one in which speculation and animal spirits have produced abnormal returns in certain investments? Is this the canary in the coal mine for a stock-market bubble or should this be ignored?
Rick, it never pays to underestimate the capacity of humans to engage in irrational speculation. As Charles MacKay said 180 years ago, “Every age has its peculiar folly—some scheme, project, or phantasy into which it plunges, spurred on either by the love of gain, the necessity of excitement, or the mere force of imitation.”
So, in the current context of the “Reddit Mob”, we can see human history repeating, a tradition where nothing succeeds like excess. Clearly, investors should be well aware that the current wave of manic speculation will end badly, just as all those that have gone before have.
We expect that traditional tools will be employed to pop the speculative bubble that has developed around heavily shorted assets, whether it be stocks or commodities. These would include margin requirements, stock loan pricing, as well as broker-dealer compliance with customer suitability requirements. Along the line of our earlier discussion, there should be an examination of whether social media has veered into areas such as investment advice that is subject to regulatory compliance.
While the unwinding of the current “Reddit Mob” mania will involve further market turbulence, Rick, investors should look to the corporate profit cycle recovery and COVID vaccination efforts as underpinnings for the stock market that will outlast the current bubble in heavily shorted assets.