I want to touch on a popular narrative at the moment that seems to be doing the rounds.
That is, growth versus value.
Why is this an important narrative for us?
Well, just take a look at how the market is functioning right now...
A couple of mega caps are holding the entirety of the indices up.
I mean, just take a look at the current divergence between growth and value...
There's a belief that every so often, investors will rotate from stocks that have outperformed the broader market...
And move into those that have traditionally underperformed.
This of course makes sense.
You want to take profits and rebalance into stocks that have more growth potential and generate higher alpha, right?
Well, I don't really buy it.
My thinking is that the most recent market sell off in equities was prompted by the reflation trade that had occurred going into Jackson Hole and coming out of it.
We can take note of this by looking at the 5s30s spread.
In my view, the market was readily poised in August for Powell to commit to overshooting inflation - the 'reflation' trade as it's known.
This is probably part of the reason why stocks sold off - an expectance of higher rates in the longer term led to investors buying short dated bonds (or using swaps) and selling longer dated bonds, causing a steeper slope upwards (that's why it's called a curve steepener).
I don't really know if it has much merit though.
This was a trade that had started a long while before.
Possibly in the shorter term reaction to Powell's average inflation targeting it did, but not as a broader theme.
And we can see that by how the 5s30s has behaved since 2018 when the curve started sloping upwards - there was no real resulting drop off in equities as the market didn't buy the belief of higher rates...
Is value really that attractive then?
This chart from Nordea would suggest otherwise if we take Europe to be a bastion of value.
Inflows into European ETFs have been dire...
And that's just not in the short term...
That's been the case for a number of years now.
Nordea actually made the case that few are buying the story of euro resurgence off of this...
Why might we look at Europe as being a place of 'value'?
Take a look at Stoxx 600 futures versus the ES.
US equities have far outperformed European equities, with the former breaching its all time high and the latter, well, being pretty crap and trading at about 50% of the move for the last few months...
But... VALUE, right?
Europe definitely could be seen as a place of value, but also is dominated by growth stocks too.
Take the P/E comparison between the Stoxx 600's largest tech firm, ASML Holdings and Apple...
48 vs 33ish.
So there's the same compounding issues with concentration occurring in Europe as there is in the US!
Let's turn our attention away from Europe for a second though and think more broadly about value.
We know from the description above that it is a rotation into stocks which have underperformed the market...
But if they have underperformed the market, why does this mean that they have a good opportunity to be a value stock now?
They've performed worse than the market for a reason, right?
Take the Russell index for example.
40% of firms in the index are unprofitable and are what I would consider 'zombies', something I've banged on about being due to central bank ZIRP and NIRP keeping them afloat.
Is buying shares in an unprofitable firm value?
Especially when there are growth stocks that have the same issues!
Here's a quote from Buffett that I feel is really important on this issue.
"I owned a windmill company at one time. Windmills are cigar butts, believe me. I bought it very cheap, I bought it at a third of working capital. And we made money out of it, but there is no repetitive money to be made on it. There is a one-time profit in something like that. And it is just not the thing to be doing". (Lecture at the University of Florida Business School, 1998).
Buffett refers to 'value' stocks as 'cigar butts'...
Stocks which you can pick up off the floor, have one puff, but then they're done.
There is little longevity in these stocks.
A common theme amongst them is that they are down and out.
So define value.
Is value simply buying a stock because it's underappreciated according to you, or is it underappreciated because it's simply not the right asset to be in?
Or are the conditions simply not right to go looking for value, which is what I want to talk about now...
Why look for value when you have seen the large caps move ~100% in 6 months in the case of the large tech firms in the US?
Of course, maybe take some money off the table and chuck it into some stocks that might follow the same kind of trajectory, but largely there is no alternative right now.
As I have mentioned time again, the large caps are trading like sovereign bonds; supported by central banks and government (indirectly) even in some cases...
And the main problem with value investing?
Here is a quote from 'The Myth of Benjamin Graham', the grand daddy of value investing.
“Graham always believed that a Dow over 100 was too high, and when it got there, he never again felt comfortable with the market. As the Dow never fell below 100 after 1942, Graham was always leaning toward being too defensive. In the early 1950s, when the Dow was about 300, he began to pull back from his business and advised his students against going into investing: The market was “too high”. (…) In 1956, the year the Dow topped 500 for the first time, he left the business for good and devoted himself to a life of pleasure.”
Graham was trying to find value in a market constantly.
I would argue that in today's market, he would get absolutely rinsed, and be on Twitter calling for a market top constantly...
And move into charging people $1000 per hour for phone calls on how to buy survival kits and the best place to store your gold...
Now, something that I could get behind is what Andrew Hart mentioned in a note to me the other day...
Why will yields rally? Well inflation expectations as expressed by breakevens have rallied hard already (see USGGBE10 Index) - and inflation lags - we have had unprecedented quantative & fiscal easing and rates are NIRP or ZIRP pretty much everywhere (and unlikely to rise as CB's clearly happy for inflation to overshoot prior tgts)....
Ignoring MSM's fear factor - Covid data is clear, hospitalisations & deaths are negligible - and I think people are a little over the restrictions which make no sense to most people - any jobs falloff maybe diluted into year end by seasonal factors (UPS already said will hire 100k for the season) - China is a net seller US Treasuries (upward pressure on yields) etc etc...and the technicals (see above) are turning.
In Europe where we do not have a big tech sector, the EY Cyclical vs Defensive chart has made new HIGHS for the move & we have a golden cross in place - the real pain will be felt by growth/value rotation in the U.S where Value/Momo remains at all time lows whereas positioning is completely the other way round.
The value vs growth trade will at some point bear fruit - the rotation will be extreme - BUT, given how big tech stocks are in every index in the U.S the first move lower will likely be indiscriminate but IF I am right on yields rallying - the bounce will be led by value.
Here's the chart that he accompanied this excerpt from his longer note with.
I agree - if yields rally then the risk free rate of return increases and growth should fall...
However, I'd also argue that many names will be caught out.
Their cost of capital will increase and due to large debt loads, we'd probably see an extortionate amount of defaults.
There's almost a two pronged issue here.
Get good growth prospects and therefore, inflation coming out of the corona virus crisis and you risk the potential for a rate rise...
Don't, and you get subdued demand, but the possibility of fiscal and monetary support.
That's the zombified economies that central bankers have created well before the crisis.
Potentially that is the Minsky Moment that many have been speaking about - not necessarily a moment, but a conditioning of business and consumer to be unbelievably sensitive to a tightening of monetary and more recently, fiscal conditions...
Remove those conditions, and it's like a drug addict going cold turkey - they become sick.
Whatever the case, I think that value has a part to play ONLY if yields rise for a sustained period...
The problem is that I don't particularly see that occurring any time soon.
What could cause inflation to rise to make this value proposition a value proposition?
Tim and I were having a chat.
He says war, if governments issue Green Bonds and go on a spending spree (I don't know if I buy that since I reckon the cash will get parked on balance sheets rather than spent, somehow), or another enormously disruptive event.
Personally, I think only extended fiscal support will contribute to inflation.
With this regard, I would be looking to Q1 of next year as a yield spike.
Well, by then I'd have expected both the EU and the US to have added to their coronavirus support efforts, the EU to the tune of $750bn and I reckon the GOP will cave in to the Dems at about $1.25tn...
Over the course of next year, I'd argue that structurally higher inflation could certainly occur.
The problem, as always, comes with the monetary stimulus side.
More QE is deflationary firstly, because it doesn't increase money velocity, and secondly, it narrows banks' net interest margins...
However, there could be a sustained difference in how this structural inflation comes about...
Take a look at the chart below.
The Fed has been financing the government.
If indeed aggregate demand shifts out to the right, we'll see the price level increase and most definitely see inflation.
Savers will likely be hit hardest first, and so will risk bearing assets as the expectation of an interest rate rise will increase.
So does that make value a good bet?
I'd argue it would make the survivors a very good bet.
By survivors, I mean those that would be able to sustain a higher cost of capital - you could argue they'd probably be in the best position.
Would I want to try and pick value?
I would rather stick with being long TIPS or play the bear steepener as outlined earlier...
Would I look to emerging markets?
Possibly, but as a dollar bull and the massive debt piles that have been accrued over the last 10 years, of which much is dollar denominated, I would be wary.
Current geopolitical tensions are heightened and emerging markets will always face the greatest susceptibility to the cascading effects of crises such as these, as well as financial contagion (see Asia in the late 90s).
Alongside that, there could be a fight to depreciate as a result of wanting to win a trade war, without having the adequate FX reserves to cope (see Turkey)...
For me, they're a no-go... for now.
Having said that, there has been massive net inflows into EM corporate debt over the last few months...
So either someone knows something I don't, they aren't worried about a currency crisis, or they're just batshit crazy.
I don't know which is worse.
To be a total nutter...
You could look to buy gold as the inflation argument becomes more and more solidified...
Remember, I've thought that the increase in gold has been a deflation hedge for the last decade, and I think that remains.
But you can have a twin narrative too...
A fear of deflation and a fear of inflation.
But I don't think the winning formula is to be found in the current conditions that value stocks find themselves in.