Mid-May Update

What makes May interesting is that there are several variables driving the market. We call this current environment a market rotation. It’s a rotation from growth stocks to value stocks. We saw this at the beginning of the year when we bought equal-weighted S&P, small caps, and structured buffered notes for clients as a hedge toward what may be a short-term rotation. Although we made these adjustments, we still have confidence in the conversation we started over a year ago: the world is changing more rapidly than ever, and the leap forward in technology and innovation from this pandemic has changed the game. 

Before we start, lets define Growth versus Value Stocks

Value Stocks - Trading lower than their fundamental value, typical of a dividend stock or lower/slower growth stock.  

Growth Stocks -Anticipated to perform significantly greater than average returns.  Trades at anticipated value as opposed to Value which trades below their fundamental value

Why a value rotation?  

Growth stocks have been on a rise over the past decade. These tech companies have not only changed the way we live, do business, are entertained, communicate, healthcare, etc., but growth stocks outperform value stocks when interest rates are low. The concern over rising interest rates theoretically changes how people view the need to take on risk. If rates are higher, one is thought to have a more stable ability to make a return, thereby forgoing some of the need to take on growth risk. Value stocks have not seen a rebound since last March until now, and still have uncertainties like:

• Inflation concerns (why investors are moving toward energy and utilities)
• Rising interest rate concerns (move to the financial sector)
• Too many fiscal stimulus concerns (dollar strength and crypto)
• Biden’s proposed tax bill (capital gains, corporate earnings, income)

While at this point it is hard to ignore value’s rise and while we don’t necessarily think it will stop tomorrow, we see a few major flaws in the continued value push. The biggest flaw is in the financial strength these sectors have, as well as their ability to compete and grow. Especially when we see blowout earnings in growth stocks with continued strong forward guidance. The market hates all of these uncertainties, and it is better to see this reaction than to witness irrational exuberance with high appetites for risk. So, perhaps it is time for value to see a bit of stabilizing, or perhaps it will continue its upward trend, but the days of growth are not over. See our previous blog on how Covid presented us an opportunity to “leap forward”.

Updates 

There is a lot to unpack, so let us take this one thought at a time.

1. Economy: It is on FIRE!

The employment report on May 7^th came in way below expectations, making people think the economy was not as strong as we all thought. But in fact, the real lesson from the employment report is, if you pay people not to work, then they won’t work - it is pretty simple.

Key takeaways: 

• Wages are rising – you've probably seen the headlines about companies like McDonald’s and Amazon raising wages to get over their recruiting slump. 
• Productivity is rising even faster – productivity was up 4.1% for the quarter, 5.4% for the year.
• When productivity rises faster than wages, companies are getting more bang for their buck from employees.

2. Businesses are seeing strong activity across the board

Key Takeaways:  

• With strong demand and limited supplies, companies have pricing power.
• Pricing power allows companies to charge more (or not discount inventory), giving them the potential for higher earnings.
• Despite already significant earnings growth being expected, that may come in too low with the supply/demand imbalance, creating supercharged earnings.

3.    Inflation: Should we be worried?

Federal Reserve: There is a lot of concern that the economy is running too hot, that it will spur too much inflation, and the Fed might be a wet blanket on the rally.  We don’t think the Fed is going to do much of anything.

Key Takeaways: 

• The Fed changed its policy to focus on long-term inflation, saying they would let inflation run above 2%, since the last 15 years it has fallen below the 2% target. Even when inflation has been high, past Fed announcements have used the “transitory” excuse to keep rates low. 
• The Fed moved growth up in the order of its concerns and also mentioned financial stability as being a policy goal.
• The Fed has explicitly said they are more concerned about risks to the downside.

Short-term inflation is related to a number of items, and many of them may, in fact, be transitory (look at me, I sound like a Fed chairman).

Key Takeaways: 

• Year over year comparisons are going to show a big increase in prices, stoking the fears of inflation, but these comps are based on abnormally low numbers from the prior year.
• We have supply constraints from the plant shutdowns and necessary rapid responses.
• Stimulus checks have led to insane retail sales. Retail sales growth grew 9.8% in March - that is CRAZY! (Average is 4.32%) If that happened every month, we would have over 100% annualized growth in retail sales!
• With the expectation of strong sales and pricing power, we are seeing inventory builds.
• Industrial production is missing expectations (1.4% versus 2.5%), further creating pricing power for companies while also having companies scramble for limited supplies. In these environments, we often see “double ordering”, where you order from two places, keep what comes first and cancel what is late. This leads to a boom-bust type of action in prices of commodities and inputs.

Long-term inflation still appears to be low. One reason for this is the deflationary pressures from innovation, both reducing prices and making more current inventory obsolete.

Key Takeaways: 

• Good deflation: Increased productivity from artificial intelligence, data mining, mobile capabilities, robotics, etc. Overall, it is about better technologies that provide more while using less.
• Bad deflation: Something that is made obsolete by technology. A fax machine is a good example. How much would you pay for a fax machine? Probably not much, and most likely less than it costs to make.

4.   The bond market, concerns over rising yields

Interest rates made a sharp increase earlier this year, and although it did not breach levels from before the pandemic started, it was a violent enough move to spook the market.

Key Takeaways: 

• Rates are where they were before the pandemic. While the concern is that rates will move higher, the reality is that they are in the same place from a year ago.
• Despite rising commodity prices, wages, and consumer prices, the bond market has stayed put since March, pointing us to another explanation.
• The rise in interest rates coincided with the Fed allowing an emergency measure to expire on March 31^st. The Fed allowed longer-term bonds to be used for capital requirements versus short-term bills. Leading up to the expiration, yields started to spike. After the expiration on March 31st, yields tapered off.

 5.   What does this mean for stocks?  Growth was outperforming value at the beginning of the year, and that all changed when interest rates started to rise sharply in February. But there is more to it.

As tax reform was being discussed, one of the proposed increases was for the long-term capital gains tax to go from 20% to 39.6%. This is a big jump, and while it was only meant for households making more than $1 million, that news, in concert of rising rates, gave investors an excuse to ring the register and dump stocks that had risen the most. This included technology stocks and high growth stocks. 

Key Takeaways: 

• There is a valid concern for the impact on growth stocks from this proposal. We are actively following this trend.  If changes are needed to the portfolio construct we will be prepared.
• There's the rub. It is unlikely that increasing the beneficial long-term capital gains rate, something that was done to intentionally encourage people to invest instead of trade, is the tax hike that will be made through a narrow margin congress going into an election. If the market thought that proposal had a good chance, we would have seen a much bigger move to the downside in the market.
• That being said, growth stocks remain under a lot of pressure as tax reform is negotiated.

Some rotation was expected from the best-performing stocks, sectors, and subclasses as the rally broadened with a growing economy. Top-performing sectors year-to-date are energy companies and financials, especially large banks. Both of these industries are interesting candidates for such strong performance because they are also two of the most threatened industries from structural changes going on in technology and consumer trends.

Key Takeaways: 

• Battery technology is advancing quickly, and electric cars are likely to be cheaper to produce and maintain in a few years, not to mention the potential for autonomous driving. Oil will see a significant drop in demand over the next 20 years as a result.
• Banks are struggling to keep up with mobile banking. JP Morgan Chase has been around for a LONG time, is the largest bank, and has a little over 50 million digital users. Venmo  was started in 2009 and also has a little over 50 million users!

6.  Where do we go from here?

We still think it is the same story. There are structural changes happening in the world as a result of going mobile, remote, electrified, data-driven, and with the help of faster computing and artificial intelligence. Companies that are taking advantage of these trends will continue to succeed, and companies that don’t will likely go out of business. We are concerned about some of the companies in trouble, and we scratch our heads when we see people paying up for their stocks and chasing them.

Key Takeaways: 

• Many of the companies that are rallying are highly levered and do not have strong balance sheets or cash positions.
• Many have not effectively invested in research and development, leaving them prone to becoming obsolete. Add to that many burned through cash over the past 12 months while technology companies pulled in mountains of cash.
• Delivery and digital have made it easy to find new products, providers, and make the switch. 

Our Take

Many of the best investments for the next five years go against the common thought. We like being unique in our ideas, and even if we are uniquely wrong, it is usually priced in. Being wrong is only really painful when you think you are safe, and then you get caught in the Black Friday rush for the door.

Final Thoughts:

• Everyone thinks interest rates are going up. While it is likely they will drift higher, it seems people are expecting a dramatic shift up. We think it will be more tranquil.
• Everyone thinks inflation is going to explode higher. We think inflation will stay within reason and the Fed will not adjust its policies.

If you want to discuss these thoughts with us further and how to adjust your plan to maximize your return, schedule an appointment by:

Calling: 973-554-1770

Emailing: myplan@greenridgeweal.wpenginepowered.com

Texting:  862-217-5344