Margin Call: Will the market sweet spot endure in 2021?
Wed, 13 Jan 2021
Markets ended 2020 against a backdrop of surging investor euphoria. As this is written, an attempted US coup d’etat, a sharp lift in bond yields and a Democratic clean-sweep saw US equities rise rather than fall. It seems that nothing can stem the tide of optimism.
While Covid-19 is resurging around the world, vaccines appear to be working, so the outlook for economic and earnings growth is very strong once re-openings occur. At the same time, central banks are running extraordinarily loose monetary policy settings. Investors earn nothing in term deposits, so there is no alternative as investors swap return-free money for hard assets such as houses or claims on assets such as equities.
We see four key questions that will determine market performance in 2021. 1. Can remarkably bullish investor sentiment be sustained? We see signs everywhere of over-stretched investor enthusiasm, but the hard part is the timing and nature of the catalyst that ends this. Possible candidates include some sort of macro, viral, or political shock - but we have seen all of these and the market has sailed higher.
We suspect a continued lift in bond yields due to inflation returning could be the key. If central banks begin to remove the punch bowl, a wall of money would rush for a very small exit door at the same time. Markets are awash with new money, bringing back uncomfortable memories of 1987 and 1999. Just a few examples that we have seen:
Exchange traded fund (ETF) inflows are off the scale and beginning to distort the security prices that they invest in. The ARK Innovation ETF (ARKK) is the poster-child but there are many others. The iShares Global Clean Energy ETF’s listed in the US and UK have surged from US$2.5bn to over US$12bn over the last two months and have dramatically impacted the Meridian Energy and Contact Energy share prices. In a piece of vicious circularity, the ETF share prices rose by 20% in each of November and December as they bought ever more of the 30 stocks that they have to own. This drove more inflows, driving share prices up…. Mr Ponzi would be proud.
US call option volume has soared to 2.5x the levels it was at the start of 2020. The gamification of such trading on commission-free trading app Robinhood is a key driver of this. According to the New York Times, Robinhood users trade 40 times more than Schwab users, with option trades being 88x greater relative to account size. At the same time, call options are disproportionately expensive versus puts for a given level of volatility.
Tesla rose by 743% in 2020 because…. They should use their absurd valuation to buy a profitable business but that would be a bit like the AOL/Time Warner deal in 1999.
According to a WSJ article sourcing Jay Ritter, the median revenue multiple for a US tech company on its first day post-IPO in 2020 was 23.9x versus a typical 6x for most of the period post the Nasdaq bubble from 2001-2019.
In 2020, there were 19 IPO’s that doubled on listing day versus 25 in the entire decade prior. Clearly, IPO quality has improved markedly.
Numerous measures show very extended sentiment levels. For example, the Citigroup Panic/Euphoria model hit a level of euphoria in mid-December that was last seen in early 2000 and implies a 100% chance of a market decline over the next 12 months (or a 100% chance of their model being re-estimated!) The CNN Fear & Greed measure briefly hit “extreme greed” before pulling back to neutral late in the month.
Short selling levels are extremely low. Estimates we saw mid-month showed that the median S&P500 stock has only 1.6% shorted versus 2.1% a year ago. Australian data shows a sharp decline and we suspect the same in NZ too.
2. Will inflation rear its head and drive higher yields? We see this as a key risk for 2021 or perhaps 2022. The housing boom is lifting housing costs and rents; labour costs are rising as immigration has halted and the minimum wage is being lifted; prices in transport and accommodation may surge upon re-opening; and an inventory shortage is lifting prices across a huge range of goods, with part of this being short-term due to Covid-19, but part of it reflecting a paradigm shift of deglobalisation as supply chains are brought closer to home. This is reversing one of the great deflationary forces of the last 20 years.
Household inflation expectations are surging, with the ANZ-Roy Morgan Consumer Confidence Survey in November and December showing CPI inflation expectations of 4.7% and 4.4% versus a more typical 3.5%. Similarly, the December ANZ Business Confidence Survey showed firms’ selling price intentions rose from +26.1 to a very high +35.1 over the month. This accords with the feedback we get from our company interactions.
No wonder longer term bond yields are now rising - the RBNZ has over-egged the cake. NZ 10-years moved from 0.46% to 0.99% in the December quarter and they have plenty of further upside potential from their extremely low levels. Who on earth would want NZ bonds at 0.9% when CPI inflation is running at 2%+?
3. Will the TINA and GAAP stock boom come to an end? While cyclical stocks did very well in the December quarter, the cheer-leading GAAP (growth at any price) and TINA (there is no alternative) darlings also generally continued to rise. On the TINA front, NZ property stocks rose by 8.5% in the quarter, while on the GAAP front, the S&P/ASX200 Information Technology Index rose by +24.7%. Neither of these make any sense given the rise in bond yields.
The valuation convexity of equity valuations at very low bond yields is huge. That’s fine if you are a cyclical and benefitting from earnings upgrades, but the risks are sizeable for other names and they may begin to notice soon. There is a strong chance that TINA and GAAP underperform in 2021.
4. Will cyclicals continue to outperform? While the current surge in Covid-19 around the world is seeing a return to restrictions, the outlook is that economies will re-open as 2021 unfolds thanks to vaccines and herd immunity from those who have caught Covid-19 already. Alongside this, we see long bond yields continuing to rise and yield curves steepen. This typically goes hand in glove with cyclical outperformance as earnings upgrades more than offset the negative discount rate impact.
In fact, this performance by cyclicals is a key reason why equities have historically tended to be a good hedge against inflation until around the 3% region. That is where higher discount rates have offset earnings upside. Infrastructure assets with inflation-linked contracts may also do well.
We do wonder if that trade-off will kick in at a lower inflation level this time around given how low discount rates are presently (it doesn’t take much of a rise to have a big valuation impact).
Subject to valuations, we are particularly optimistic on the outlook for soft commodities, base metals, mining services, building materials and financials.
It may be that not all cyclicals keep running. We are wary of some retailers that have surged on the “Covid-19 nesting trade”, with a big multiple being applied to earnings that may not be repeated in 2021/22. After a wonderful 2020, the balance of risks may change for iron ore. Brazilian (and other) production will rise sharply later this year, China is making noises about keeping a lid on steel production and a huge African production increase looks set to be financed by China in the medium-term.
To conclude, remember that all predictions are wrong, especially about the future. Since 2011, it has been an amazing period to be an equity investor thanks to the generosity of central banks. However, mass-market retail investors have only joined the party from mid-2020 onwards. The party is rocking and maybe it keeps rocking for a while longer - but remember not to over-stay the welcome.
Right now, markets are in a sweet-spot where interest rates are ultra-low but the outlook for earnings growth is strong as economies re-open. This may carry on for a period but the stars are aligning for a change in the underlying market drivers, just as new investors are flooding into the market.
GAAP and TINA stocks have been superb investments for the last several years but the December quarter saw cyclicals strike back. The obvious tail-risk in both directions centres around central banks. We suspect the key question for 2021 will be whether they remove the punch-bowl as inflation reappears and speculative fervour gets out of hand.