Portfolio Update & "The Narrative"
Let's Make Sense of This Short Term Narrative & Update on Buys/Sells I made
“The Narrative”
This week I have heard a new thing, “preserve your mental capital”. This is how I know we are in a bear market and people are becoming extremely uncomfortable. But truthfully, I believe this may be stemming from a lack of understanding what’s going on what to look for on where a bottom might be. In addition, it’s emotionally distressing to watch wealth go down and almost euphoric to watch it go up. The financial markets, at times, are just like a Casino.
Truthfully, there is nothing surprising in regards to what is happening and the price action we are facing. Let’s explain “the Macro Trade”.
Short Long Duration, Long Consumer Staples, Utilities & Energy
Long duration is “growth”, or assets that have some sort of future baked into the price. Consumer staples (defensives) are stocks like Walmart, Costco, etc. Energy typically is oil and gas companies Like Exxon Mobil. Utilities are typically going to be your basic needs and infrastructure stocks that American need to pay.
YTD Performance of the S&P 500
This macro trade has been going on since the back half of 2021, especially energy stocks. Obviously, since the price of crude rose to over $100/barrel, funds are running toward these companies like they’re never going out of business. More importantly, you notice that consumer staples, utilities, agricultural and health care are performing very well. There are relatively easy explanations as to why these sectors are out performing relative to tech, innovation and basically every stock outside of major indices.
Reason #1: The Federal Reserve is tightening monetary policy “Short Long-Duration”
This is all anyone ever talks about these days and it’s likely the primary reason everybody is afraid to buy something. The reason why has to do with the equity premium on stocks. By definition equity premium is the difference between the return on a stock and the return on a bond. Typically, it’s positive—meaning stock returns are higher—although it can be negative when the stock market goes through some rough times.
Basically, it’s the premium that you pay to take the risk of corporate equities. The market theory is that investors are typically going to be risk adverse, meaning that they are always looking for yield in the least risky way possible. The bench mark risk-less yield in the financial markets is defined by the 10-year bond. As the bond goes higher, stocks need to go lower to justify the “premium” of risk. As bond yields go lower, stocks look more attractive because the risk-free-yield is so low, investors will look for riskier investments for long term yield. This is working off the principle that equities and bonds are always competing for a limited supply of liquidity in the financial markets.
This means that, as the Fed raises the Federal Funds Rate, fixed income (bonds) looks more attractive to investors. Money flows to bonds and the price investors are willing to pay for equities must come down. This is called “multiple compression”, or the action of valuation on the stock declining.
This is the perfect example of (software) stock multiples expanding and contracting due to bond yields and monetary policy
Reason #2: The Fed might “break something”, which creates risk-off sentiment “Long Utilities, Healthcare and Consumer Staples”
This is where it gets crazy, especially when factoring in the valuations on some of these “risk off” stocks and comparing them to “long duration”. Let’s run over a few forward P/E multiples to some of these “value” stocks.
Consumer Staples Forward P/E:
$COST 35x with 10% growth
$WMT 23x with 5% growth
$KO 26x with flat to no growth
Utilities Forward P/E with no growth:
$DUK 20x, no growth
$SO 20x, with declining growth
$XEL 23x, fluctuating growth
Healthcare Forward P/E:
$JNJ 17x, fluctuating growth over the past 4-5 years
$LLY 44x TTM P/E (forward P/E not defined), less than 5% growth
When risk-off sentiment happens, Wall Street and fund managers move closer to the bench marks, or the S&P 500, because “that’s what is working” and they don’t want to get fired. More importantly, risk-off brings a flight to safety trade where investors want to buy stocks with earnings right NOW because they’ve always been around for years and years. This is best explained by the price action that occurred recently in 2018 when the Fed last “broke” something. Look at the price action between Coca-Cola and the NASDAQ $IXIC from September 2018 - December 2018.
Coca-Cola
NASDAQ Composite
The flight to safety is real during uncertain times. Investors seek to put money into assets that have a lower beta or perceived, “less volatility”. Funny thing is, that’s where all the opportunity is.
Reason #3: The devaluation of fiat currency and the war in Ukraine and Russia “Long Energy and Commodities”
The best way to think about this is the “inflation trade”, or, I should say, that’s what the play on commodities is all about. When the value of currencies world wide decline, which they are, due to excess money supply, then items that have a fixed value in nature tend to appreciate. This has created a commodity appreciation. However, this problem was further exacerbated by the war in Russia and Ukraine.
Ukraine is considered Europes “bread basket” meaning they are a major exporter of wheat. What this has done is create supply side inflation to wheat prices, as you can see by the chart below. Around invasion day, you notice that wheat has went up drastically.
From the Russian end of things, they are the 2nd largest or the largest exporter of oil and energy products. When Russia decided to invade Ukraine, the U.S. put sanctions on Russian oil as well as other parts of the world. This created another factor for “supply driven inflation” but more importantly, created a higher profit margin for oil and gas companies. This has created a large rally in energy stocks for the past 2 years (since the bottom of the COVID-19 pandemic). This has also been exacerbated by government policy in Europe and the U.S.
On a more complex topic, due to monetary policy, Zoltan Pozsar (global head of short term interest rate strategy at Credit Suisse) has proposed a different concept for the bull market in commodities aside from the war. This has to do with monetary policy and the secular shift away from fiat currency, as well as the replacement of the U.S. Dollar as the reserve currency. The interest thing with this topic is that it is working slower, on a more secular basis, along with the rise in China. Cyclical forces typically drive shorter term price moves like what we have seen recently in oil and other commodity prices. A further in depth note on a topic like this is best suited for a later publication.
The Inevitable End to this Cyclical Trade
I have never been in a market cycle that hasn’t has a beginning, middle, and an end. Typically, sentiment is a major gauge of where we are in the current market cycle as well as leading indicators of cyclical macro forces. In this particular instance, there is a lot of weakness in this trade from an overcrowded perspective. In my opinion, the herd has pushed up valuations of consumer staples to extreme levels and the cyclical nature of oil’s boom and busts leave limited room to establishing a long that can yield any sort of major reward. This was of particular importance when I noticed the comments when Eric making an observation with this tweet:
Once again, the herd of a retail crowd is coming to defend a current market cycle trade when it doesn’t make sense. In the past year, I have seen this with ARKK stocks, SPAC’s (particular EV SPAC’s), and individual businesses like $NET or $ASAN reaching 100x+ P/S ratio. It’s of particular interest when I see investors recommending oil and gas stocks on my comments. This typically tells me the orange doesn’t have much juice left in the squeeze.
It’s never different this time, ever. Cyclical markets are just that, cyclical, and the market will reverse no matter how much anybody believe this thesis will last forever.
Knowing the Markets will Reverse, this Leads me to My Portfolio Update/Strategy, What to Look for in the Week Ahead and Notable Moves from Last Week
This upcoming week has a major catalyst that can lead to a change in market sentiment and potentially, a change in how 2022 finishes. Let me explain the chain of events a little more and why my stock picking strategy ties into my long term macro thesis.
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