April 5, 2021
Recent Articles:
I finished off my Bitcoin series over the past month with two articles on the protocol:
This newsletter dives into the current macroeconomic situation and covers various stocks to provide a sample of equity valuations that exist in today’s market.
Bouncing From Extremes
The year 2020 was arguably the most macro-heavy year in modern financial history, meaning that big external factors and policy responses had a huge impact on individual stock performance. The global economy sustained the biggest deflationary shock in decades, followed by the biggest mix of fiscal and monetary stimulus since World War II.
As that was happening, the market was rapidly repricing assets, from depressed to euphoric, and with different sectors moving towards extremes at different times. In my most recent premium report for subscribers, I summarized it with an engineering analogy:
For anyone who has vague familiarity with electrical engineering or control system design, the global asset market (inclusive of policy response) is basically behaving like an underdamped stable system. For the uninitiated in terms of what the heck that means, here is a chart of an arbitrary electrical signal (in blue) trying to hit a target level (red dotted line), with a series of big overshoots in either direction until it starts to balance around its target, with some economic annotations added to make the point:
Chart Source: Dynamics and Control
In early and mid-2020, the real economy was devastated, and big-money investors didn’t want to touch cyclical stocks that were exposed to this economic uncertainty. Banks, commodity producers, industrials, and other cyclical companies were left for dead at cheap levels. Investors instead piled money into tech stocks at almost any price, since they were generally immune from, or even benefitting from, the pandemic.
Then, as massive fiscal stimulus started to take effect, and as vaccines were announced later in 2020, investors started rotating out of overvalued tech/growth stocks and more into those abandoned cyclical/value stocks, and many of them have had very strong price movements since then.
With that in mind, this newsletter issue provides an update for various parts of the equity market.
Value vs Growth
This chart is the Russell 1000 value index divided by the Russell 1000 growth index. Whenever the line is going higher, it means value stocks on average are outperforming. Whenever the line is going lower, it means growth stocks on average are outperforming.
The value factor consists significantly of financials, industrials, and healthcare, with substantial energy/commodity exposure as well. The growth factor consists significantly of information technology and consumer discretionary, with very little financials or energy/commodities.
In the first half of 2020, the line went vertically downward with a sharp burst of growth stocks outperforming value stocks, after already having gradually outperformed over the past decade.
After this sharp period of growth stock outperformance, the growth-to-value-rotation happened in the beginning of September. This chart shows a close-up of the previous chart, zoomed into the past three years:
Equal Weight vs Market Weight
Similarly, the equal weight S&P 500 has a long-term performance pattern against the normal market weight S&P 500, and is also working along the same timeline as these other ratios.
The market weight index ranks the top 500 companies by total value, and so the index is way more invested in Apple than, say, American Express. The top 10 companies account for about 27% of the 500-company index at the moment.
The equal weight version takes the same 500 companies but then invests in each one equally and rebalances every quarter, which makes it less concentrated. The top 10 companies of the index only represent 2% of the equal-weight version, since each of the 500 companies make up an equal 0.2% of the index.
This chart shows the ratio of the S&P 500 equal weight index vs the S&P 500 market weight index. When it’s going up, the equal weight version is outperforming.
Usually, the equal weight version underperforms late in a business cycle, and outperforms early in a business cycle, and has historically outperformed over the very long run. Because the market weight version is currently so concentrated in growth stocks, this ratio bottomed (equal weight began outperforming) on September 1, 2020 exactly when the value factor began outperforming the growth factor.
Gold and Interest Rates
Lastly, the 10-year Treasury yield hit a local bottom, and gold hit a local top, in August 2020, less than a month prior to those big stock rotations. This chart shows the gold price in blue on the left axis, and the 10-year Treasury interest rate in red on the right axis:
Chart Source: St. Louis Fed
Rising rates have been good for bank stocks lately, and these rising rates represented the market expecting a more reflationary outcome, which generally occurs when value/cyclical stocks are doing well in general.
More recently, since early March 2021, the value/growth ratio has been taking a break and drifting back slightly in growth’s favor, and gold stocks showed some signs of consolidating sideways from their several-month correction. When one side of the trade outperforms very strongly over a short period of time, there tends to be a period of mean reversion.
Individual Stock Examples
Isolating a few stocks can be instructive as an example of how these various sectors gyrated over the past year or two.
For these charts, the black line is the stock price, and the blue line is what the stock price would be if it was at its average earnings multiple over the chart period. The charts include 2-3 years of analyst consensus forward earnings estimates as well.
Global economic growth began to slow in the second half of 2018, and during 2019 it was in a clear downward trajectory, before the pandemic. Throughout 2019, investors piled into defensive utilities, like Southern Co (SO), but starting in 2020 that enthusiasm wore off:
Chart Source: F.A.S.T. Graphs
As we moved forward into 2020, it was technology’s time to shine. Apple’s (AAPL) earnings were pretty normal over the past couple years, but with a backdrop of lower interest rates and its perceived safety in a world of pandemic/shutdown uncertainty, investors piled into it during the first half of 2020. As previously mentioned, the black line is the stock price and the blue line is what the price would be at historically average multiples of annual earnings, which shows the big divergence:
Chart Source: F.A.S.T. Graphs
On the other hand, investors got the heck out of energy producers and transporters through most of 2020, but have been trickling back in since late last year while tech stocks have been correcting downward. A lot of pipeline businesses, including Enterprise Products Partners (EPD) below, remain near all-time low valuations with high distribution yields:
Chart Source: F.A.S.T. Graphs
Bank stocks like Bank of Nova Scotia (BNS) have been somewhere in the middle. They underperformed in 2019 as growth slowed. Then, they took an earnings hit and a bigger stock price hit in 2020, but are bouncing back and anticipating good 2021 and 2022 results:
Chart Source: F.A.S.T. Graphs
Many gold stocks like Franco-Nevada (FNV) had a strong 2019 as global growth slowed and interest rates fell. Then, they overshot their fundamentals to the upside in mid-2020 before falling out of favor later in the year as growth and interest rates went up. They likely undershot their fundamentals here in early 2021, and lately have been showing some signs of life again.
Chart Source: F.A.S.T. Graphs
The healthcare sector is one of the oddballs here, in the sense that they never really got the memo that there was anything unusual happening. Amgen (AMGN) for example neither overshot nor undershot to extremes. An investor looking back years from now at most healthcare stocks wouldn’t realize that anything unusual happened in 2020:
Chart Source: F.A.S.T. Graphs
There were also one-off oddballs. Disney (DIS) for example had their earnings collapse and their stock price soar, as investors re-rated them as a streaming company for the time being. Earnings aren’t expected to fully recover until 2024 but the market drove the price to fresh all time highs anyway:
Chart Source: F.A.S.T. Graphs
Going back to some tech stocks, there are some that I consider to be “growth at a reasonable price” stocks, meaning they overshot in 2020, corrected/consolidated for a time as their fundamentals kept growing, and so more recently have looked somewhat interesting again. Here’s Adobe (ADBE) for example:
Chart Source: F.A.S.T. Graphs
I added Adobe to the newsletter portfolio in January 2019 at about $233/share, and dollar-cost averaged into it for a while. I sold it in September 2020 at about $465/share when it seemed a bit stretched, and used that money for some more cyclical opportunities. However, after it went flat-to-down for the next six months while the underlying business continued to grow, I bought it back in March 2021 for about $440/share.
These large events throughout 2020 got a lot of the big macro moves out of the way. Some things got either so cheap or so expensive at certain points over the past year that buying or selling them was straightforward. I didn’t get every position perfect but in general I tilted the portfolio into whatever was cheap at a given time.
As we go forward, and some of the underlying economic metrics and policy responses move in less extreme ways than during the pandemic year, individual stocks will likely start to matter more- than just broad themes. “Tech” as a sector isn’t good enough as an investment theme now, in other words. Which tech stocks? At which prices? Similarly, “value” as a factor isn’t good enough. Which value stocks?
Going forward, I still favor the value side of the equity spectrum, but I think there’s a mix of stocks from both camps that can do well, and many others that are overvalued.
Next Test: Low Base Effects
People often think in year-over-year terms, and by extension most financial metrics are reported in year-over-year terms.
For example, we think of most investments in terms of their expected annualized rate of return. We measure yields in terms of how much interest on principal they provide in a year. When we talk about inflation, we compare prices to a year ago. Many prices for big items, like rent or insurance premiums, or tuition, tend to go up once per year.
So, the inflation numbers for April and May (reported in May and June) of this year will be interesting, since they are compared to low base effects from their equivalent months in 2020:
Chart Source: St. Louis Fed
Here is a back-of-the-envelope calculation. CPI was 263.161 in February 2021 (reported in March), which was a 0.35% month-over-month increase vs January 2021. If March 2021 CPI increases by just 0.25% from February 2021, and April 2021 CPI increases just 0.25% from March 2021, then the April 2021 CPI will be 264.48. This isn’t very fast inflation, and yet it would be more than 3.2% above April 2020, since April 2020 was a low month (easy year-over-year base effects). That would be the highest year-over-year CPI print in about a decade.
Chart Source: St. Louis Fed
The market may look through that. If investors focus on month-over-month or two-year-average figures, those numbers may not be particularly interesting during this upcoming late spring period. It is specifically the year-over-year numbers that will be notable.
As it relates to inflation from there, we will have to see what happens with ongoing stimulus. The Biden administration is working on a multi-trillion infrastructure aid plan for 2021/2022, and the question will be whether it can get through the tightly-divided Senate.
Portfolio Updates
I have several investment accounts, and I provide updates on my asset allocation and investment selections for some of the portfolios in each newsletter issue every six weeks.
These portfolios include the model portfolio account specifically for this newsletter and my relatively passive indexed retirement account. Members of my premium research service also have access to three additional model portfolios and my other holdings, with more frequent updates.
I use a free account at Personal Capital to easily keep track of all my accounts and monitor my net worth.
M1 Finance Newsletter Portfolio
I started this account in September 2018 with $10k of new capital, and I put new money in regularly. Currently I put in $1,000 per month.
It’s one of my smallest accounts, but the goal is for the portfolio to be accessible and to show newsletter readers my best representation of where I think value is in the market. It’s a low-turnover multi-asset globally diversified portfolio that focuses on liquid investments and is scalable to virtually any size.
I chose M1 Finance because their platform is commission-free and allows for a combo of ETF and individual stock selection with automatic and/or manual rebalancing. It makes for a great model portfolio with high flexibility, and it’s the investment platform I recommend to most people. (See my disclosure policy here regarding my affiliation with M1.)
And here’s the breakdown of the holdings in those slices:
Changes since the previous issue:
I made a few changes since the February newsletter. I sold the copper stocks after big gains and consolidated them into a broad commodities ETF (GUNR). I also sold Capri (CPRI) and Lam Research (LRCX) after big gains. I added Adobe (ADBE) and Bristol Myers Squibb (BMY) to the portfolio in place of those sales.
Some folks ask me about bitcoin as it relates to this portfolio. M1 Finance doesn’t have a way to hold bitcoin, but I hold it in self-custody and via the Grayscale Bitcoin Trust (GBTC) in my personal accounts.
Primary Retirement Portfolio
My retirement portfolio consists of index funds that automatically rebalance themselves regularly, and I rarely make changes.
Here’s the allocation today:
From 2010 through 2016, this account was aggressively positioned with 90% in equities and enjoyed the long bull market.
Starting in 2017, in order to preserve capital, I dialed my equity allocation down to 60% (40% domestic, 20% foreign) and increased allocations to short-term bonds and cash to 40%. This was due to higher stock valuations and being later in the market cycle more generally.
After equities took a big hit in Q1 2020, I shifted some of the bonds back to equities, and it is now 71% equities (46% domestic, 25% foreign), and short-term bonds and cash is now down to 29%. For my TSP readers, this is equivalent to the 2040 Lifecycle Fund.
This is an example of a portfolio strategy that takes a rather hands-off approach but that still makes a tactical adjustment every few years if needed, based on market conditions, which reduces volatility and makes the retirement account feel less like a casino than many indices these days.
This employer-based retirement account is limited to a very small number of funds to invest in, so my flexibility is limited compared to my other accounts. I would, for example, have more exposure to precious metals, commodities, and digital assets in that account if it were an option.
Other Model Portfolios and Accounts
I have three other real-money model portfolios that I share within my premium research service, including:
- Fortress Income Portfolio
- ETF-Only Portfolio
- No Limits Portfolio
Plus I have larger personal accounts at Fidelity and Schwab, and I share those within the service as well.
Final Thoughts: Infrastructure and Taxes
Upcoming US fiscal proposals include plans to provide significant funds for infrastructure projects and to increase the headline federal corporate tax rate from 21% to 28%.
Historically, the budget reconciliation process that Democrats used to get the recent $1.9 trillion aid package through the Senate without Republican votes or the possibility of a filibuster (just a simple 51-vote majority including the vice president as the tie-breaker) is only used once per year. However, there may be some technicalities that allow a second one in the same year.
If the technicalities don’t work out, then absent a bipartisan agreement with at least 10 Republican senators to overcome a filibuster, infrastructure spending and tax changes may wait until next year. We should expect a large fiscal package this year or next, but the timing could be tricky and is something I’ll be monitoring. The timing and magnitude of that bill could affect numerous things including inflation/deflation and which stock sectors do well.
Previous aid bills were not paid for with taxes; they were funded via debt issuance, and the central bank created a lot of new base money to buy that debt issuance. As policymakers look around for ways to reign in the fiscal deficit going forward, they’ll gravitate towards areas that would be politically easier to raise taxes on.
A big tailwind for US equity performance over the past few decades was constantly decreasing effective corpore tax rates. This chart shows the effective federal corporate tax rate in red and the total federal and state effective tax rate in blue.
Chart Source: St. Louis Fed
Starting from the post-WWII period, effective corporate tax rates were around 40%, and began declining from there. Today they’re in the 10-15% range. Corporations on average pay less than the headline 21% rate due to various exemptions that they have lobbied for successfully over the years. The headline rate was 35% until recent years, but went down to 21% during the Trump administration.
The Biden administration’s proposal would raise the headline to 28%, which is the mid-point between 35% and 21%. This would remove half of the tax cut, but still keep the rate lower than it was before the tax cut.
We can also look at the sources of federal revenue as a percentage of the total. Over the years, corporate taxes and excise taxes have gone down as a share of federal revenue, income tax has been a rather constant share, and payroll taxes have made up a growing share of revenue.
Chart Source: TPC
Raising income taxes or payroll taxes for most people is very unpopular, while partially reversing the corporate tax decrease from a few years ago is politically easier. However, it’s unclear if that proposal can get through the Senate, as some centrist Democrats oppose it and most Republicans oppose it.
One reason I like to have global equity exposure rather than purely US equity exposure, is to reduce in the impact of tax changes. Sector diversification doesn’t mean as much if all of the companies in a portfolio are in the same country, where a government administration can raise or lower their taxes across the board.
These large fiscal packages and potential tax changes will be an ongoing macro variable to be aware of with regards to US equity performance (and more broadly, global equity performance) as we move through 2021 and 2022, and may be more of a subject in my future newsletters or articles as we get more clarity on them.
Best regards,
