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Jan 19 2021

Factors: Ain’t Misbehavin’

  • Jan 19, 2021

Investment styles and factors are generally interpreted as having an inherent preference for either bullish or bearish market environments. The theoretical tilt of each style is based on its design and its sensitivity to economic, profit, and valuation cycles. However, theory and practice do not always agree, and we must look to actual performance to confirm our impressions.

Read this week's Major Trend. 

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There are certainly many signs the stock market could be getting out over its skis and a correction may be looming. A Russell 2000 small cap index that has more than doubled from its lows last year, extremely high valuations compared to historic norms, an explosion in SPACs, IPOs, and M&A activity, several scary investment sentiment indicators, outsized and over-the-top economic policy accommodation, ridiculous recent price surges in heavily shorted stocks, and the price of Crypto going Crazy!

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Sometimes the simplest explanation is best. Most believe global economic growth will be strong this year. As vaccines work to dampen (if not end) COVID-19, massive policy accommodation, the restart of social industries, and the revival of private-player confidence and glee should boost economic growth across the globe. Added to that are strong pent-up demand and record-high savings.

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Economic programs traditionally take time to improve unemployment after a recession. However, the COVID-19 crisis created a unique divergence within the job market that will not be solved by customary economic policies, but rather, by vaccinations!

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Read this week's Major Trend. 

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There are always conflicting signals surrounding the stock market. Today is no exception. Valuations are extremely high, but yields are near record lows. Recent economic reports have weakened due to the winter’s COVID-19 surge, but current vaccinations (although slow) highlight how close the U.S. is to a more extensive economic reopening.

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The CPI numbers are largely in line with expectations. A blue sweep and a new Fed regime is a powerful combination that should be taken seriously. We now believe the odds of higher inflation are materially better than just a month ago.

 

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Like the Saturday Night Live “Cowbell” skit, among policy officials and politicians, the solution to “everything Pandemic” has been, We Need “MORE Stimulus!”

Undoubtedly, the COVID-19 crisis has been a rare if not unique situation, incredibly serious, and has caused widespread and immense hardship. Due to that, we received a $2 trillion fiscal CARES package last spring, a massive increase in quantitative easing resulting in an 80% increase in the Federal Reserve’s balance sheet since last February, and a surge to an all-time-high 26% annual growth in the U.S. M2-money supply.

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As the stock market continues to surge higher in the New Year, investor anxieties surrounding excessive valuation risk are also rising. Many increasingly worry that the bull market has entered a manic bubble reminiscent of the late 1990s.

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Read this week's Major Trend. 

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Forecasting GDP is hardly our forte, but 2021 should see a very big gain in real output. Our current guess is for real GDP to grow 5% this year. Statistically, though, that doesn’t imply that the stock market’s move will also be large (or even of the same “sign”). 

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Inflation surprises have run hotter in the U.S. than in the rest of the world, no doubt reflecting the strength of major currencies versus the U.S. dollar. 

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The GS Scores handled the chaotic, 2020 market well, turning in a +10.1% return spread. The lone black-eye was November, when the Pfizer vaccine news upended quant factors and produced the worst single-day performance in GS Score history.

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The 200-day “report card” for this bull market shows the best initial-performance gain of all postwar bulls, but it’s come at a price. Investor sentiment is above levels seen at the same point of past bull markets… and there are the valuations. 

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We’ve updated our time-cycle composite for 2021 and it looks like it will be a year of “two halves,” with a low-vol bull-market extension in the first half of the year, followed by a much more volatile second half. This also appears to extend outside the U.S.

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We take a look at our historical analysis of industry-group portfolios to see how the “Dreams” and “Nightmares” from 2019 fared in 2020. The industry-group composition of the 2020 Dream and Nightmare portfolios is also presented.

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In April 2018, armed with a large number of ETFs and long-enough historical data, we applied our back-testing methodology for individual stocks to the universe of ETFs to determine if the same (or some) of those components could useful for assessing ETF performance prospects. One of the factors we reviewed was fund flow (adjusted by AUM), which revealed that those ETFs experiencing the largest asset inflows proceeded to significantly underperform.

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Despite fresh all-time highs in the stock market, heavy net outflow from equity focused mutual funds shows no sign of abating. With 2020 data through November, fund flows for MFs that focus on domestic or foreign equities saw an incredible $569 billion head for the exits.

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Every year, there is plenty of investment advice on the best “buys” for the New Year! However, in 2021, it may prove just as important to avoid certain areas of the financial markets.

The current consensus forecast for U.S. real GDP growth is 3.9% in 2021, representing the fastest rate since 2000. Our prediction is for 6% growth—the fastest since 1984! Either way, due to massive policy stimulus and the expectation that vaccinations will finally bring COVID-19 under control, U.S. economic growth should be strong this year. Whether currently a bull or a bear, the fact that real U.S. economic growth is poised for a healthy advance should make everyone leery of traditional “defensive investments.”

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Bring on the New Year! Bring on Vaccinations! Bring on Re-openings! Bring on Mobility! Bring on Socializing! Bring on Freedom (from my basement)! Bye Masks, Purell, 6-feet of distancing, Quarantine, Zoom, Curbside Pickups, and Sickness! And “Farewell” to far too many Loved Ones! Good Riddance COVID-19!

Here are a few guesses, conjectures, and maybe even some stupid thoughts for the New Year.

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As we turn the page on 2020, a peek ahead to the S&P 500’s 2021 operating earnings is probably in order. You never know, earnings and valuations might be important again one day.

 

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The stock market has received plenty of support during this pandemic. Massive bond-buying has ballooned the Federal Reserve’s balance sheet from about $4 trillion to $7.5 trillion. The annual M2 money supply has surged from 6% to 26%, and federal-deficit spending as a percent of nominal GDP has exploded from less than 5% to more than 15%. What’s more, policy officials around the globe have replicated this unprecedented support!

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The trade-weighted U.S. Dollar Index (DXY) has been weak since mid-May. This week’s downside pressure has pushed it below 90—within an eyelash of its early-2018 bottom. If it breaches the 2018 low, there is very little technical resistance until it moves down to near 80. This year, the dollar peaked above 100, so a drop to 80 would represent a significant 20% cheapening in just a few months.

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Pfizer’s November 9th announcement of an effective COVID-19 vaccine triggered the most extensive one-day rotation in style factors we have ever seen. Investors flipped from Large Growth—the market’s dominating style over the past few years—and found new friends in Value and Small Cap. This rotation continued through November, to the point that Value and Small Cap each had their best single-month return in 30 years.

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Valuation metrics consistently suggest the S&P 500 stock price index is extremely highly-priced. How far can the stock market run when it’s already at record high levels? Although its valuation relative to its trailing 12-month earnings per share (EPS) is equally excessive, the S&P 500 was similarly priced at the start of each of the last three bull markets. It is worth considering how those past bull markets prospered in the face of equally lofty valuations—do their examples provide a pathway for the contemporary bull market?

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Lately, investor-sentiment measures have become an increasing concern. Several metrics, including the AAII Bulls less Bears, the put/call ratio, CNN’s Fear & Greed Index, the smart-money/dumb-money indicator, and the investment newsletter writers’ sentiment index all suggest optimism has become excessive.

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Even after watershed events COVID-19 and MMT, some things never change.

Next year will begin like almost every one of the past dozen years, with economists and strategists expecting bond yields to rise.

Unlike most of those years, though, there are several measures of “cyclical pressures” that would seem to give them a good chance of being right. The best-known among these might be the “Copper/Gold Ratio,” popularized by DoubleLine’s Jeffrey Gundlach, which suggests 10-Yr. Treasury yields should be around double their current level (Chart 1).

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The CPI numbers are slightly ahead of expectations. The reflation trade and the weaker dollar trade are very popular but they are no no-brainers. Our moderate inflation view is supported by the latest reading of our Inflation Scorecard.

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Is the U.S. economy being battered by the winter surge in COVID-19 and increasing caution among consumers and businesses facing the pending expiration of the Cares Act? Concerns have escalated recently, as COVID-19 cases spike, major metropolitan areas announce renewed shutdowns, and government officials are seemingly unable to agree on a package for additional stimulus. Adding to the worries was a disappointing jobs report last week.

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Driven by massive government stimulus, an imminent vaccine rollout, and the expectation of record earnings in 2021, investors seem to be on the verge of embracing a move away from Large Cap Growth stocks in earnest. The leading candidates offered as broad-based alternatives to Large Growth (LG) include Value, Small Caps, and Emerging Markets.

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In the last four years, the U.S. stock market has been dominated by growth stocks! During this time, growth has outpaced value by an historic amount, measured back to at least 1926. This trend has received considerable attention. Growth managers have been rewarded handsomely, while value managers have suffered multiple years of underperformance and declining business.

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The 2020 post-election stock surge looks and feels a lot like the 2016 “Trump Bump.” But, of course there’s a spoiler. The Biden Bump started with a Normalized P/E level about 30% higher than the one prevailing on election eve of 2016 (26.8x versus 20.5x, respectively). 

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Many pundits argue that sky-high valuations on stay-at-home stocks “prove” equity investors somehow remain fearful. It’s a nuanced, short-term argument, and there’s merit to it: We’d argue such fears have produced terrific relative values among “SMID” Cap stocks. 

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The “Biden Bump” brushed away any lingering technical deficiencies in the stock market, but that happy state of affairs is reflected in extremely frothy-looking short-term sentiment indictors. We are riding the momentum to some extent, but with a lower base-level of exposure.

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We studied several “popular trades” and there are good reasons to be on board with most of them, but none can be viewed as a no-brainer.

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