TUG OF WAR
VALUE VS. CONSENSUS: WHY THESE TWO LONG- STANDING INVESTOR COMMANDMENTS ARE FIGHTING IT OUT IN THE MARKETS.
Those who have followed me over the years know what a profound influence Wall Street veteran Bob Farrell has had on my career. He has 10 commandments for successful investing. Rule No. 1 posits that “markets tend to return to the mean over time,” while Rule No. 9 stipulates that “when all the experts and forecasts agree, something else is going to happen.” Today, those two rules appear to be in a heavyweight fight.
As to Rule No. 1, I would be the first to tell you that the current rotation into value stocks has been a long time coming. The price- tobook ratio of the Russell 1000 Growth index traded more than five times that of its value just two months ago, and the forward priceto- earnings ratio is close to twice as high. Tally up Microsoft Corp., Apple Inc., Amazon. com Inc., Facebook Inc., Netflix Inc., Tesla Inc. and Alphabet Inc. and you get a collective market cap of US$7.9 trillion. You can fit three Canadian economies in that valuation pool, or the Russell 2000 small- cap universe three times over.
In any event, we have a catalyst for this market action at least from the vaccine standpoint. And we have had the lopsided math and extreme bifurcation in the market for some time. Not that growth doesn’t deserve to command a higher valuation than the true-blue cyclicals, but it has always been about the magnitude.
This rotation from bonds and gold to stocks, and the shift from growth and defensive names toward value and cyclicals within stocks, brings up Rule No. 9. Every strategist on Wall Street is advocating for this rotation; it has become commonplace, and it has become very much the consensus.
In terms of all the “experts and forecasts” agreeing, as per Bob’s Rule No. 9, look at sentiment and market positioning. The latest Commitment of Traders report shows that the noncommercial investors in the Chicago Board of Trade futures and options pits have cut their net long position on the 10- year note by nearly 60 per cent since the end of September. At the same time, they have added to their net long S& P 500 contracts on the CME by 25 per cent, and, in a vivid sign of how popular the pro- cyclical value trade has become, the speculators have boosted their net long positions on the Russell 2000 by an amazing 340 per cent in just six weeks.
Bullish sentiment is simply off the charts. Last week’s Investors Intelligence data showed the bull camp expanding to 59.2 per cent from 53.6 per cent, while the bear share dwindled to 19.4 per cent from 20.6 per cent. We are back to an extreme gap of 40 percentage points between bulls and bears. Caveat emptor.
Every economist, strategist and analyst already had a vaccine in their forecast for 2021, so at best the recent positive news moves up the timing a few months, but it isn’t an entirely new revelation. I’m not convinced the latest vaccine news was enough on its own, even with the amazing efficacy levels, to generate what has been a five- standard deviation move in the most cyclical parts of the stock market.
There are also questions around how immunizing most of the world’s population could prove logistically challenging. In a perverse sense, the improved prospects for a vaccine could reduce urgency around extending fiscal support, and we are hearing more about this from many Republicans who only want a skinny fiscal bill.
The biggest risk right now, obviously, is the spreading virus. We have now seen 100,000 cases or more in the United States in each of the past 10 days. They are soon on their way to over 200,000 in the next 60 days as winter arrives. These numbers have soared three-fold since early October, to record highs, and are rising substantially in 48 of the 50 states. Shutdowns at the state level are also coming back.
We are now at the stage where hospital capacity is being compromised again. Available beds, especially in ICUS, have sharply fallen. The health-care system is being seriously strained again from both sides: there’s higher labour turnover and attrition with vacant health-care positions not being filled. Is it well recognized that since February, the U. S. is short 600,000 ( or four per cent) medical system workers? This is a travesty.
To be sure, there’s been a rotation out of the “stay- athome” theme companies to those names in travel, leisure and hospitality that were beaten down by the pandemic ever since the Pfizer Inc. news. Some say we can now look across the proverbial valley. To which I say: why should we be looking across a valley that has so many landmines on the way? There is another little matter we have on our hands right now, the nontrivial chance we slip into a double- dip recession before we ever get the vaccine boosts.
Now, I have gone on record and stated that we are in a depression — not a recession, but a depression. And I think the dynamics of a depression are different than they are in a recession, because depressions invoke a secular change in behaviour. Classic business cycle recessions are forgotten about within a year after they end. At a minimum, depressions entail a prolonged period of weak economic growth, widespread excess capacity and a fundamental shift in attitudes toward spending and credit.
The way I see it, the future, at least for the near- to intermediate-term, is one in which working from home is certainly going to be a more dominant force, with obvious negative implications for commercial real estate, but positive implications for internet infrastructure, computer hardware and video conferencing. At the same time, urban working and living will undergo a profound shift.
There is also a secular change and much greater awareness coming out of this period of history beyond just hygiene: a much greater appreciation for space, as in open space. There is going to be a sharp reduction in travel to work and travel in general — nothing here that is very good for the auto or office real estate sectors, that’s for sure.
As an aside, two things are going to get worse from a future GDP growth perspective, even if everyone gets inoculated by the first quarter. One is our aging demographics. The median age of the baby-boomer community is now 66 years old and it will be 76 in a decade. As if we don’t have a social security and pension crisis ahead of us. This is a ticking time bomb for fiscal finances at a time when they are only made sustainable by near-zero rates.
The other dynamic is the debt, which has only worsened. We come out of the crisis with debt at every level of society — government, business and consumer — at an unheard- of 392-per-cent ratio to GDP. At the end of 2019, that metric was 326 per cent. Aging demographics and a massive debt overhang will act as significant constraints on aggregate demand growth that will outlast the brief boost to domestic demand we’ll get once the vaccine arrives.
Coming out of this pandemic, however, I do see some bullish secular themes emerging. As we go into an era of elevated personal savings rates, people are going to focus on what they need, not what they want. Anything related to e-commerce, 5G, cloud services and wiring up your home to become your new office is in a budding new secular growth phase. Delivery services have now become essential. I should tack on that grocery chains with online services come out of this as a winner. Microsoft has become a utility. One could argue that Amazon has become a utility. One could also argue that Google has become a utility. It’s apparent to me that you want to have exposure to health care because this clearly is an under- invested area. Though, as I have said, I’d prefer to pick these plays up at better prices than we have today, and I would be an avid buyer of defensive- growth on any significant pullback.
One last thing to mention is what I would add to Bob Farrell’s 10 rules if I ever had the chance. Though it is hard to improve on perfection, I would add something on the need, at all times, to invest around scarcity of value. Focus your investments on what is scarce globally, which are four areas:
❚ Growth is scarce, which is why you want growth stocks once this mean- reversion trade to value runs its course.
❚ And what else is scarce is yield … so you want income at a reasonable price at all times. Dividend yield and dividend growth — I am thinking here about Canadian banks and telecom and select REITS.
❚ The third scarce resource is safety: what is safe in your asset mix? I always get guffaws when I mention the necessity of having a substantial portion of the portfolio in long- duration, high- quality bonds — yes, even at today’s low yields. The 1.62-per-cent yield on the U. S. 30- year Treasury is a giant in a world where 30- year German bunds are minus 18 basis points, Japanese government bonds at 64 basis points and U. K. gilts at 85 basis points. You own bonds in the portfolio to manage your risk, so ignore those folks who tell you to dump your bonds because yields are too low. They are low because, as a price, the bond market is telling you that we are heading into a future of ultra-low expected returns.
There is inflation risk and duration risk in Treasuries, to be sure, but they are unique in their payment safety characteristics. They are the only assets where security and certainty of payment is assured and guaranteed. The Treasury Strip is the benchmark risk- free asset for funding actuarial liabilities. It is the only investment vehicle with no default risk, no call risk and, hence, no reinvestment risk. It’s the only thing you can buy where you know exactly how much money you will have 30 years from now.
❚ The final item that is scarce is what I call inexpensive assets, since everything is off the charts expensive now that central banks have all but destroyed the equity risk premium. But there are far- away places such as China and Southeast Asia where assets are cheap, where price- to- earnings multiples are in the low teens, and who are emerging in much better economic and financial shape coming out of the pandemic. To which I conclude for the benefit of investors who can invest globally, “Go East young man, and woman.”
people are going to focus on what they need, not what they want.