Extreme Election Scenarios

• Technology stocks peaked on September 2^nd_.
• Our recent cautionary advice sets up election investment opportunities.
• We examine a blue wave and a potential Amy Coney Barret decided Trump Victory.
• Invest in value and sell growth. Commodities could boom.
• Cyclical turnarounds in natural gas and cannabis.

Our September letter argued that a generational peak in technology stocks occurred on September 2nd and it mirrors the 2000 technology peak which preceded an 83% decline in the NASDAQ 100.“With this profound experience, we again advise reallocating away from technology stocks, based on their parabolic appreciation, gap openings and extreme valuations. Failure to manage this massive tech bubble could have a lifestyle or career-changing consequences for some and possibly many.”

Our September market call continues to prove accurate and our rationale prescient. Earnings comparisons for tech are weakening. Tech earnings momentum will weaken further as the economy recovers when first half 2021 tech earnings compare against their COVID-19 stay-at-home 2020 blowout earnings. Decelerating earnings momentum will pressure tech stocks while lockdown victim stocks will show improving earnings. As the bubble psychology which drove FAANG stocks’ parabolic run is confronted with lower tech stock prices, weakening earnings comparisons, antitrust actions, and threatened regulatory action, we expect further tech stock declines mirroring the 2000 precedent.

Below is a 21 year chart of the NASDAQ 100 or QQQ. It shows a parabolic run in 1999 that peaked in 2000 in a similar manner as the 2020 run. The March 2000 peak initially cracked but it took six months until the downtrend took clear control.

Last month, we advised raising cash and reducing market exposure because an undecided election litigated in the courts could lead to riots raising uncertainty in this historically overvalued stock market.

“While many investment professionals dismiss stock market risks associated with the Presidential election, we fear election consequences could have potentially large negative impacts on the stock market because of the market’s historically high valuations. One risk we fear is an undecided election, where historically high partisanship, violent extremism, uncertainty, and election-deciding legal cases could erode market confidence and faith in United States’ democratic institutions. This result will be exacerbated and cheered by adversarial nation states and anti-establishment extremists.”

The hung election risk seems now highly probable. It is widely expected that not all ballots will be counted on election night and some ballot collection will continue based on different state rules. A 2000 Bush v. Gore like litigation could again playout. Philadelphia and Pennsylvania could be ground central of a ballot dispute based on late ballot counting, Pennsylvania’s 20 delegate prize, disputes regarding rules and a sketchy election reputation. With uncertainty and rising COVID-19 cases, more economically restrictive measures taken to address COVID-19 could add further pressures on the S&P 500.

How the election will play out is unknowable. Below are some scenarios which could offer opportunities for our clients and readers.

Scenario One: blue wave
If Joe Biden wins the Presidency and Democrats control both the Senate and the House of Representatives, the most left-leaning prospects could play out. With a sweep, there is the possibility that several tax and spending policies could be enacted which would be bad for financial assets. Biden has said he will reverse the Trump tax cuts and that taxes will rise by $4 trillion. This could reverse the stock market gains of the Trump Administration as corporate tax rates will reverse from 21% back to 28% and will mathematically cut after-tax earnings. Part of the Trump stock market rally was the immediate consequence of lower taxes. A reversal of those policies will lead to a reduction in S&P earnings and downward pressure on the stock market. The prospects of a larger equity market decline would be higher with a blue wave.With today’s unprecedented level of US government debt, more aggressive deficit spending to drive the economy could lead to the further debasement of the US dollar. The current $27 trillion debt compares to a current GDP of $21 trillion which is over 100%. This debt to GDP ratio has not been this high since World War II and ratios over 100% raise long-term solvency concerns. The US Debt Clock, below, shows the US National Debt and US Gross Domestic Product and other interesting data.

The blue wave may lead to massive fiscal stimulus or spending like the $3 trillion “Heroes Act”. Unrestrained spending and debt accumulation should help infrastructure and healthcare stocks but will debase the US dollar which will help gold and commodities at the expense of private sector growth.

Scenario Two: Trump Wins in the Courts

Newly minted Supreme Court Justice Amy Coney Barret could conceivably cast a deciding vote in the re-election of Donald Trump. Before this happens, the market will weaken creating equity values which are compelling. In this hung election scenario, with a Trump win, the deregulatory agenda of the Trump administration will benefit energy and bank stocks.

More broadly speaking, the reduced prospect of higher corporate taxes should lead to a more robust market rebound than with a Biden win.

The valuation ratio between growth and value is at an extreme that is rare and generational. Just as allocating away from tech makes sense, allocating to value could significantly enhance portfolio performance in the coming months and years.

The chart below reflects the ratio of the Wilshire Growth Index to Value Index, which is at an extreme not seen in 20 years and last seen at the height of the technology bubble.

DoubleLine CEO Jeffrey Gundlach has been waiting for a shift to commodities which is part and parcel of the growth to value rotation argument. “Commodities are very, very cheap. Commodities have long cycles, as well. A fascinating chart [above] has been circulating in the investment industry. It compares the total return of the Standard & Poor’s 500 index to the total return of the Goldman Sachs Commodity Index, and it goes in tremendous cycles. In the 1970s, commodities started to outperform. They outperformed the S&P 500 by 800%, and then gave it all back. Then there was another wave up, and commodities outperformed again by 800%, actually 900%, and that continued into 2008” said Jeffrey Gundlach. Though the chart and quote are dated, this extreme has become more acute with the collapse in oil and stock market rally, which we believe peaked on September 2 with the FAANG technology stock top.

The Chart below shows this extreme of value versus growth in the ratio of the S&P 500 to the Goldman Sachs commodity index.

The two top quantitative factors which drive stock performance are earnings momentum and price momentum. Once a trend begins, money follows earnings and price trends. This creates a feedback loop where momentum attracts more momentum and speculative capital. Prices rise parabolically until they stop. When the music stops, often when valuations and short term appreciation have grown extreme, the feedback loop of momentum begins to reverse. Growth stocks have turned parabolic and now the upside feedback loop is reversing. We also believe that value, cyclical, lockdown victim stocks, reopening stocks, commodities, commodity stocks, emerging markets, and inflationary cyclicals should begin to generate earnings momentum out of a cyclical downturn.

Schwab’s LizAnn Sonders notes the recovery range of estimates: Optimistic: 6 get approved & rolled out soon, leading to 220 million deliveries by July 2021. Pessimistic: 4 get approved, but supplies are delayed, and it takes until Q2 2023.

The critical factor is that vaccines will come and that will lead to lockdown victims experiencing rising revenues and earnings with their business recovering. This COVID-19 cycle reversion will power cyclical and value stock compared to gig-economy stocks which have been immune if not outright beneficiaries of the pandemic.

The policy of buying low and selling high is emblematic of the rotation from growth to value. With the peak in technology, momentum money will look for new homes as the FAANG stocks, large cap tech and QQQ should continue to lose its fast money sponsorship.

Energy has been a widow maker. The XLE Energy Select SPDR Fund is down 71.5% since June 2014. The environmental response to fossil fuel carbon emissions have doomed the industry that powered the industrial revolution. Coal and oil have been especially hurt due to their large carbon footprint within the fossil fuel complex. However, natural gas is a clean burning gas which has replace coal fired plants and provides energy to power US factories and heat homes without the environmental consequence of oil and coal. Natural gas has also suffered as its production in the age of fracking has produced natural gas in such abundance that the commodity has been in a bear market for 11 years. Persistent declining natural gas prices have made natural gas producers and processors struggle financially.

This story, however, has changed with the collapse of oil prices earlier this year with the OPEC price dispute and the COVID-19 economic decline. With the collapse in oil prices, 496 or 65% of US oil wells stopped production. With that massive shutdown, the production of associated natural gas declined. Further, capital no longer is interested in funding drillers or anything to do with the carbon economy. Consequently, the supply of natural gas has begun to shrink, while the long term demand outlook for natural gas and natural gas liquids remains quite bright. The changing dynamic of decreasing supply and persistent demand has laid the groundwork for higher natural gas prices.

We own and like Antero Midstream Corporation (AM) and Antero Resources Corporation (AR) as two large pure-play natural gas stocks that offer considerable upside. AM and AR reported this week and their earnings were very compelling. AR continues to buy in its own bonds or stock which is a powerful signal for any investor. AR had a massive debt load which they have been aggressively paying down. With strong natural gas prices, AR is generating strong operating metrics that allow themselves to further pay down debt. The management team is former Lehman Brothers investment bankers who own significant personal shareholdings. Large insider ownership, smart incentivized management, a cyclical bottom in natural gas prices, and being a purely natural gas play are compelling drivers for AR and AM. AM yields 20.5% which we believe will be maintained as AR owns 28% of AM and is a significant cash flow beneficiary of AM’s high dividend yield.

Over the next two years, AR ($3.4/share) could trade to $20/share, and AM ($5.73/share) could trade to $13/share. These two companies could provide meaningful upside in a market that may prove challenging in the months and years ahead.

Cannabis:

We have been researching the hemp and marijuana industry. The medical case for the use of CBD and THC is proven in science and pharmacology, but the cannabis industry is in the early years of its development. CBD is the non-hallucinatory cannabinoid byproduct of a hemp plant. THC is the hallucinatory cannabinoid byproduct of a marijuana plant. Hemp was made legal in 2018 under the US Farm Act. Marijuana is legal in some states for recreational and medicinal usage but is a Drug Enforcement Agency “DEA” schedule one drug. This regulation restricts marijuana and THC’s unfettered use, research, development, and availability.

The FDA approved Epidiolex in 2018, the FDA’s first CBD based pharmaceutical drug for two forms of epilepsy and approved Epidiolex for an additional indication in August 2020. The FDA has approved three synthetic forms of THC for medicinal usage: Marinol (dronabinol), Syndros (dronabinol), and Cesamet (nabilone). FDA approval is the gold standard based on the most stringent safety and efficacy studies and these approvals demonstrate the medicinal and scientific legitimacy of cannabinoid drug products. Anecdotal evidence supports CBD’s use in treating anxiety, sleep disorders, aches and pains which has driven robust growth for CBD as a dietary supplement.

The December 22, 2018 Farm Bill legalized hemp farming in the United States. This legislation led to massive hemp overproduction which created a glut in hemp biomass and hemp crude oil. Leading hemp producing states have been experiencing rapid growth and some are replacing their tobacco crops with hemp.

Hemp has compelling ESG characteristics beyond its healthcare benefits and promise. Growing hemp has a negative carbon footprint. Hemp is effective in removing pollution from the soil and was used to remediate nuclear contamination in the soil around Chernobyl. The cannabis sector is beginning to recover from a cyclical downturn and benefit from the growing usage of CBD and THC for its medicinal benefits.

The chart below of the US Marijuana Index shows an 82% decline from 2015 to 2016, a 452% rise from 2016 to 2018, and an 83% decline from 2018 to its March 2020 COVID-19 bottom. The sector has doubled off the March low, but has been enjoying growing usage and awareness, suggesting that Cannabis – both hemp and marijuana – are nearing a cyclical low.

This election could generate significant market volatility both in the coming weeks and years. The determination of the leadership and their differing views on governance suggests that being prepared for various potential outcomes is an important and timely exercise.

The peaking of technology stocks is adding momentum to a powerful rotation from technology stocks like the FAANG stocks to value stocks. Prudent reallocation in the coming weeks and years is a critical discipline for portfolio growth and risk management.

We encourage you to recognize that generational changes are occurring in today’s historically overvalued stock market. The political consequences of this election could also be massive. Be prepared. There is enormous opportunity in a period of change.

We welcome your thoughts and concerns.