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Jul 21 2021

Tactical Junk

  • Jul 21, 2021

High yield bonds returned a robust 15.4% in the year ending June 30, extending a winning streak that produced a 56.4% cumulative return since the end of 2015.  After a quick, severe drawdown at the height of the COVID-19 scare, junk bonds have experienced nearly ideal market conditions, heralding a return to trends that have been in place for several years. The post-pandemic move toward this record low has been a boon to high yield bond investors, but it has also created a significant risk of reversal.  We believe most things in the financial markets are defined by cycles, with Treasury yields and credit spreads no exception.  Tight readings for both rate series demand that we consider the possibility that a cyclical reversal could weigh on junk bond prices going forward.

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In the second quarter, the U.S. economy suffered another significant inventory liquidation: As a percent of real GDP, inventory reductions subtracted 1.1% from overall real growth. As shown in Chart 1, as a percent of real GDP (red dotted line), last quarter’s inventory draw-down was the second-largest since 2020 and the fifth-largest back to 1950. On a trailing four-quarter basis (blue line), the paring down of inventories in relation to real GDP in the contemporary period is also the fifth-largest since 1950!

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If you want to see a rocket ship, there’s no need to crane your neck upwards to see the latest exploits of our billionaire space cowboys. Rather, look to our earnings glidepath chart and marvel at the contrails of the 2021 full year operating earnings for the S&P 500.  

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Since 1871, the U.S. stock market’s average, or normal P/E (price/earnings) valuation is 14.6x its trailing 12-month earnings per share (EPS). With the S&P 500 P/E currently above 28x, the stock market appears frighteningly overvalued relative to its 150-year history—this may eventually prove to be an accurate warning of a pending, catastrophic stock market event. Nobody knows for sure. However, using this long-term historical valuation as the “average” or “normal” benchmark for U.S. stocks should be weighed with some skepticism for two primary reasons.

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Worries about an impending economic slowdown have recently increased.

First, COVID-related economic shutdowns have again been implemented in some countries, several U.S. jurisdictions reinstated mask mandates, there is growing concern from health authorities about breakout cases, renewed hospitalization-capacity pressure, and anxieties about unvaccinated children going back to school. This has all raised the possibility of another COVID economic shutdown.

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Those who heeded the old advice to “Sell In May” have missed out on an additional 5% gain (and counting) so far in 2021. However, the best way to have played this seasonal anomaly over the years was not to have “sold-out,” but rather to have “reduced the beta” of one’s equity holdings versus cutting equity exposure outright. That strategy has paid-off handsomely the last three months, even as this “Nothin’ Matters And What If It Did” stock-market powers higher.

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A few unrelated charts with some “short” comments.

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The S&P 500 Technology sector has had an amazing run. Not quite a replay of the 1990s’ dot-com era, but close. In the last five years, S&P Tech has outperformed the overall S&P 500 Index by more than +72% (total return) or +11.5% per annum! Not only is Tech performance remarkable during this period, but the sector very infrequently trailed the S&P 500 (and by just modest amounts).

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Inflation and its potential impact on the stock market is the topic du jour, resurrecting ideas that were in vogue 30- to 40-years ago.

Steve Leuthold’s 1980 book, The Myths of Inflation and Investing, provided an exhaustive review of the evidence. But for lighter reading, more appropriate for a summer Friday, we revisit the “Rule of Twenty” developed by strategist Jim Moltz in the early 1980s.

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It’s been a lousy week for inflation! Early Tuesday morning, the NFIB Small-Business Price Survey for June reportedly rose to its highest level since 1981. That was shortly followed by the release of the Consumer Price Index, showing Core CPI inflation surged by 0.9% in June, more than double the 0.4% consensus expectation. As the day progressed, both the CRB Raw Industrial Commodity Price Index and the price of crude oil reached new recovery highs. Then, on Wednesday, it was reported that the Core Producer Price Index jumped by 1% compared to an expectation of only 0.5%. So, in surreal fashion, the last twelve months’ consumer- and producer-inflation rates are now suddenly 5.4% and 7.3%, respectively.

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The CPI numbers exceeded the most aggressive market estimates. The bond market’s message is quite clear: the concerns of Fed tightening outweighs inflation. While it’s still debatable whether inflation is “transitory”, the reflation trade still gets the benefit of the doubt. 

 

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A host of factors have recently been pressuring the stock market. The S&P 500 Index has nearly doubled from its bear-market low in March 2020, signifying one of the strongest 16-month gains in post-war history! After such a robust, uninterrupted advance, it simply feels overdue for a correction. Moreover, compared to historical norms, valuation measures portray an extremely overvalued market.

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At today’s 30.8x, the Peak P/E stands in the 99th percentile on all time horizons except the “New Era” (1995-to-date). Yet, that’s still five “handles” below the 35.8x all-time high recorded in December 1999. If that figure is matched, the S&P 500 will top 5,000. 

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Statistically, when jobs are “easy to get”—as all the survey evidence now indicates—attractive long-term returns for stocks typically become “hard to get.”

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The Fed surprised the market with a hawkish projection of two rate hikes in 2023. Real yields did not move up as they typically do with such an episode. Overall, the damage was limited to the reflation trade, and the risk-rally is intact.

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Automotive Retail currently ranks Attractive per our Group Selection Scores. This group offers a range of exposure to a bumpy—but recovering—U.S.-auto industry made up of car dealerships and auto parts & service retailers.

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While not yet set in stone, it is the consensus view that infrastructure spending will be raised to a higher level for the next few years compared to past baseline expenditures. Although the exact numbers are still unknown, we examined the President Biden-endorsed bipartisan plan to provide a picture of the relative scale of the anticipated spending in the context of historical trends. In addition, we identified a group of industries that may be beneficiaries of the proposal.

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In the last couple of years, the direction of the U.S. dollar has been driving stock market leadership.

Investors primarily focus on earnings momentum, interest rates, and potential fiscal- or monetary-policy changes. However, recently, it may be the U.S. dollar that is making one’s portfolio “sing” or “stink,” as shown in Chart 1.

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The current bull market has had a great start during its first 15 months! The S&P 500 Index is up slightly more than +90% from its March 2020 bear-market low. Most valuation metrics suggest a highly-priced market; there has been a pick-up in taper talk, a looming fiscal cliff, and this month, the economy appears poised to achieve its peak growth for the expansion. It’s a good time to consider just how much capacity this bull market might have left?

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It’s near the year’s mid-point and U.S. equities are doing what they’ve done nearly every year since the onset of the Great Financial Crisis: trouncing their foreign counterparts. The S&P 500’s YTD gain of 13.5% is about 500 basis points better than EAFE’s, and 800 basis points above that of the MSCI Emerging Markets Index.

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Despite reports of inflation soaring, the Federal Reserve is maintaining the fed funds rate near zero and is persistently expanding QE purchases. These actions certainly leave an impression that nobody is in charge or even concerned about inflation getting out of control. This feeling of vulnerability is made even worse because bond vigilantes appear equally nonchalant regarding potential inflation risks.

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As we near the end of the second quarter, we are struck by how much sentiment has shifted compared to the end of the first quarter. Perhaps this sentiment swing is best illustrated by the bond market.

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As is periodically the case, the Federal Reserve captured all the attention last week—particularly after bond and stock markets were so reactionary to Fed meeting notes, dot-plot changes, and Chairman Powell’s post-meeting press conference.

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The Value style has broadly underperformed for more than ten years, and the blame for this dismal decade has often been placed squarely on the Price to Book metric. Could it be that Price to Book’s sullied reputation is undeserved?

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U.S. inflation has surged in recent months for a number of reasons. The most concerning one is the extent to which this elevated level of inflation is due to the overuse and abuse of monetary and fiscal stimulus? Suppose this bout of inflation is primarily the result of rising monetary velocity, or it reflects heightened inflation expectations causing consumers to spend stimulus checks and run-down savings quickly. In that case, it will prove to be a serious and sustained inflationary challenge. Some of it is simply the base effect. A year ago, many prices dropped abnormally, and even a return to more standard pricing will produce a temporary, outsized inflation rate.

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The performance derby between actively managed portfolios and passive benchmarks is strongly influenced by market conditions.  Active manager success rates are cyclical, but not random, and are driven by slippage created from style, size, and weighting considerations that result from the imperfect slotting of active portfolios into single style boxes.  Moreover, this slippage can be defined and measured, and shows a clear correlation with relative return spreads between benchmarks and their opposite boxes.

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Inflation has arrived, and investors, understandably, are worried about the impact it will ultimately have on the stock market. The S&P GSCI Commodity Price Index has risen by almost 70% in the last year, and annual consumer price inflation has adjusted upward to 5% from essentially zero. Consumer inflation is now at its highest level since 2008 and will likely soon reach a level not seen since the early 1980s!

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Given how fast the economy is recovering, could the stock market soon struggle with a scarcity of SLACK? Wall Street’s dirty little secret is that, historically, the stock market does best when there is slack on Main Street. This is illustrated in Chart 1, which shows how the S&P 500 has performed at various unemployment rates during the post-war period.

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CPI figures for the last two months have pummeled estimates and set multiyear records. Equity and fixed income markets seem to be comfortable in the Fed’s assessment that these high inflation prints are transitory.

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In the May Green Book, and again in the May 21st issue of “Chart of the Week,” we discussed the trailing one-year correlation between weekly percentage changes in the S&P 500 and the 10-year Treasury bond yield. Rollovers from high levels in this correlation have signaled most of the important pullbacks in the bond market over the last 20 years.

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Since 2008, the “direction” of the 10-year bond yield has been highly correlated with stock market leadership. Although the level and direction of yields have always been significant factors for stock investors, their role has seemingly become much more pronounced, since 2008, relative to earlier years. That is, since the Great Financial Crisis, the bond market has been determining, or at least coincidently signaling, which stock cars will be the winners and the losers.

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After years of underperformance, investors who pay attention to both Momentum and Value are finally being rewarded. The turnaround has been substantial, but the relative valuation of expensive Momentum vs. cheap Momentum stocks is still extremely elevated by historical standards.

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Impressive strength across the factor spectrum implies that the recent pop in the long-time beaten-down Financials sector should have more room to run. We highlight five attractively-rated Financials groups for investment ideas beyond the popular big-bank-concentrated Financial sector ETFs.

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Most people agree that growth stocks have longer duration than value, but few bother to back this up with numbers. Our implied equity-duration study says the conventional wisdom is right: Growth stocks do have longer duration. But... the devil is in the details.

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