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Good Morning. This is the first letter of August, and my last until September. I take my sabbatical once every four years until after Labor Day. I’ll either write the great American novel or hang out with my wife and kids. In the next three weeks, Unhedged will appear three times a week, written by Eitan and the legend of the market Katie Martin. For the next two weeks, you’ll have to make do without Unhedged. Enjoy the rest of your summer, everyone. Complaints about today’s letter go directly to Ethan at firstname.lastname@example.org.
What kind of rally is this anyway?
Between the beginning of the year and June 16, the S&P 500 fell 23%. Since then, the market has clawed back a healthy portion of those losses. The index is now down just 13% from its peak. What is happening and why?
Some basic observations:
The rally was a US-led event. European, UK, Japanese, Chinese and emerging market indices did not perform well.
The rally was led by growth stocks. The Russell Growth Index is up 17% from the lows, beating the S&P’s 13% and the Russell Value’s 9. connect Bloomberg this weekend claims that there is a defensive rationale for the rise, citing inflows into dividend-focused ETFs – but this is not reflected in the performance of those ETFs, which lag significantly behind the S&P.
With a few exceptions, the sector’s performance has reversed what we saw in the sell-off at the start of the year. The tech and consumer sectors that did so poorly then lead the way now (the S&P discretionary sector has some tech goodness; it’s 38% weighted to Amazon and Tesla). The energy moved from the first place to the last.
Looking at the performance of individual names, the pattern of reversals continues, with high-risk companies like Etsy, Tesla, Ford, Netflix and DR Horton that have suffered the most with frequency posting huge gains in recent rallies.
It is important to note that this growing, technological and happy rally occurred simultaneously with a considerable loosening of financial conditions, both expected and actual.
Start with the change in Fed funds futures (the expected interest rate implied by the options market). They have been cut down especially since the rally started, and so have we specified Last week, the rally coincided with the terminal rate peak (the high point) and the reversal.
Interest rates are now expected to decline steadily until 2023. This is not the only type of easing that has occurred. That major global staple, the dollar, peaked on July 14th. Oil has dropped from $120 to $98 since June. The Vix Volatility Index fell from 24 to 21. The credit spreads were also recorded slightly in July. The entire financial system, which had been holding its breath, took a small but noticeable breath.
So, with all this in mind, is this a bear market rally, or has the market turned a corner? Bear market rallies are common things. I count four or maybe five during the recession of 2007-2009, when the two-month increase of 12% in the spring of ’08 looked most similar to the current one. There were three big ones, all around 20 percent, between the 2000-2003 crash.
It is clear that what has happened in the last 6 weeks is a softening of inflation and therefore interest rate expectations. The shares responded by rising, which makes sense. If the rally is going to stick, then the market must be right about inflation. However, this is a necessary and not a sufficient condition. The market must also be right that next year we will have a shallow recession or no recession at all. As Unhedged has pointed out several times in this space, earnings expectations and stock valuations do not price in truly painful economic developments.
The yield curve tells a slightly different story. The 10-2-year curve has inverted, and the more significant 10-3-month curve is rushing in that direction.
Why does the yield curve predict recessions? Short interest is economically important and controlled by the Fed. Long rates are also important, but are largely determined by the market. They reflect a certain approximation of a natural interest rate (plus a term premium that varies greatly). When the Fed pushes short interest rates higher than long interest rates, it has made short interest rates artificially high and grinds the gears of the economy. Grind them long enough and hard enough and a recession will occur, if history is any guide.
There’s talk right now that short interest rates can’t be nearly neutral when they’re at 2-something percent and inflation is at eight. But what matters is not the calculation of the hypothetical real interest rate, but what the Fed’s actions do to the economy. And despite the latest signs of easing in the conditions mentioned above (interest rate expectations, the dollar, oil, the Vix) it seems that the Fed’s actions are affecting the real economy. Witness trends in housing, commodities, investments and business sentiment.
The rise in stocks represents a collective bet that inflation is almost whipped up, and that the Fed will recognize this fact at exactly the right moment, and avoid a recession.
Growth in value stocks, redux
On Friday I said – unashamedly parroting the work of Ben Arnold Smithers – that in the five-year period before the start of the pandemic, the average quarterly earnings growth of the MSCI Europe value index was actually higher than that of the corresponding growth index, making the names of the two seem a little odd.
Some mathematically savvy readers have pointed out that this is a statistical holdover from the fact that value stocks have more volatile earnings than growth stocks. They exhibit very high growth as they retrace their gains from the trench, distorting the average. Median rather than average growth would be a better metric to use.
That makes perfect sense to me, given that value indices tend to have a heavy weighting of cyclical stocks (although Duncan Lamont, another Schroders guy, Claims which is less true than it used to be).
But proving this point is not a simple matter. I went back and looked at the EPS growth of Russell’s U.S. Growth and Value Indices, for which there is more data, all the way back to 1996. Again, over that span, the average annual growth in EPS was greater relative to value (9 percent) than growth (7.7) But the median value was also higher: 9.4 to 7.6. Excluding the volatile epidemic period does not change things.
Only looking at compounded annual growth over the entire 26-year period gives a higher result for growth (7.4 percent) than the value (6.3).
But it’s still far too simple. You will have to carefully examine, for example, what is excluded and included in the index to get a more satisfactory result. One reader wrote that if you rank stocks into quintiles by valuation, and then look at the median EPS growth of each quintile, you see that the highest (largest) quintile is clearly growing faster than lower quintiles. I haven’t tested this result, but this method seems like the correct method.
One good read
Matt Klein combs through the oddities in last week’s GDP report at over break, makes me cringe at a simplistic reading of the numbers. He shows why the economy may not be contracting, although it is almost certainly slowing. The Overshoot requires a subscription; You should get one.
Reading the rally | Financial Times Source link Reading the rally | Financial Times