Strong economic growth and inflation are persistently driving the “great rotation” from growth stocks to cyclical stocks. Were it not for the historically low Treasury yields, which make stocks attractive by comparison, the S&P 500 stock index’s overvaluation would be problematic. As vaccination levels rise toward herd immunity, economic activity is rapidly recovering. Vaccinations in the United States should approach 70% and drive the US and the global economic recovery.
Inflation continues to march higher as Friday’s PCE Price index – the Fed’s preferred inflation gauge — rose 0.6% m/m in April and was up 3.6% yr/yr. Inflation expectations for the year ahead rose to a record 4.6% according to the University of Michigan’s index of Consumer sentiment. Persistently high inflation will debunk the Fed’s “transitory” inflationary projections and could undermine both the stock and bond markets. As this week’s Barron’s cover indicates, “everything” is in short supply. “Too many dollars chasing too few goods” is the textbook definition of inflation. With inflation this hot, the reallocation of investments from bonds and high growth stocks to economically cyclical and commodity sensitive stocks is the only logical choice in this extraordinary late cycle bull market.
Today’s stock market is a casino of massive liquidity. Sector bubbles in Reddit Meme Stocks, SPACs, electric vehicles, and cryptocurrency stocks are flaming out after rewarding investor’s wild speculation. As the market’s extraordinary liquidity declines with growing inflation and economic strength, this bull market’s days are numbered.
Market Psychology:
Human nature is a constant. That is why stock chart patterns can be so telling. Irrational exuberance is observed in upward parabolic spikes (think 2000) and abject fear is seen in accelerating waterfall-like declines. [Think 1987 and 2008-9.] Today’s bursting sector bubbles are punishing speculators and eroding euphoria.
“All through time, people have basically acted and reacted the same way in the market as a result of: greed, fear, ignorance, and hope. That is why the numerical formations and patterns recur on a constant basis.”
Jesse Livermore – a trading legend.
The drawing below reflects the psychology and sentiment associated with a typical boom-bust cycle.
“There is nothing new on Wall Street or in stock speculation. What has happened in the past will happen again, and again, and again. This is because human nature does not change, and it is human emotion, solidly build into human nature, that always gets in the way of human intelligence. Of this, I am sure.”
Jesse Livermore, Reminiscences of a Stock Trader.
Source: Reminiscences of a Stock Trader, Edwin LeFevre
The price charts below show Bitcoin and Tesla’s parabolic price moves and retracements. This year’s underperformance of leading technology stocks forebodes a broader market peak. The QQQ NASDAQ 100’s five-year parabolic run appears to be topping out. This cooling off of bubble stocks should dampen investor exuberance which has grown out of spectacular returns generated off of last March’s low.
Investment inflows into technology and stay-at-home stocks are shifting toward commodity and reopening stocks.
Black Wednesday for Big Oil:
On Wednesday, May 26th, 2021, the Hague Court ordered Shell to cut its emissions by 45% within the next 10 years. This decision, in combination with shareholder votes and board changes at Exxon Mobil Corporation and Chevron Corporation, suggest climate activists are winning their war against fossil fuels. This court ruling will force Royal Dutch Shell PLC to slash at least a million barrels of oil and gas from its fossil fuel production every day, at a cost of several billion dollars a year.
These developments may present a silver lining for natural gas stocks. Natural gas, a clean fossil fuel, can fill the power gap between worldwide energy demand and the relative inefficiencies of solar and wind alternatives. Natural gas may be critical to keep “the lights on” while cleaner alternatives are deployed over the coming decades.
Client holdings, Antero Resources, Inc. (AR) and Antero Midstream, Inc. (AM) which rallied last year 13 x and 5 x off their March lows are, when combined, one of the most integrated natural gas producers in the United States and still attractive investments benefitting from global natural gas growth. In addition, we are adding to Tellurian, Inc. (TELL) to client portfolios. TELL is an emerging global LNG distributor founded by Charif Souki the Co-founder and former CEO of Cheniere Energy, Inc. (LNG). This week, Tellurian, Inc. announced a 10 year agreement with Gunvor Group for 3 mm tonnes per annum MTPA of LNG that company presentations report are worth $12 billion in revenues over the next decade.
As the global economy recovers, we anticipate strong energy demand and natural gas pure plays like AR, AM, and TELL could experience years of high industry and economic growth.
Market Valuation:
The market’s greatest vulnerability remains the likelihood of meaningful inflation which will lead to significantly higher bond yields in the years ahead. The market has largely accepted the idea that inflation will be transitory as Federal Reserve Chairman Jerome Powell has stated. However, anecdotal evidence of shortages and rising commodity prices, suggest the idea of 2% inflation for a few quarters is wishful thinking.
The Fed Model Risk Premium chart below-left shows analysts are already modeling a healthy rebound in earnings approaching $200 heading into 2022. See the second panel (red line).
Unfortunately, if 10-year US Treasury yields rise toward historically normal levels, equity valuations will be challenged as bonds become a compelling alternative to stocks.
The Cyclically Adjusted Price Earnings (CAPE) ratio created by Nobel Laureate Robert Shiller is shown in the chart above(right). Today’s CAPE ratio exceeds that of 1929’s and is only exceeded by the tech bubble in 2000.
We expect inflation in the mid-single digits by yearend and 10-year US Treasury rates rising to 4% within the next two years. With a 4% US Treasury yield, the risk premium should drop to 0 – a level last seen during the 1999 to 2001 tech bubble. From its 2000 peak, NASDAQ QQQ declined 82% and the S&P 500 declined 51%. During this period and until 2008 commodity investments were market leaders providing significant returns to investors.
Conclusion:
While we cannot know how high inflation will rise and where interest rates will go, the likely consequence of higher inflation and rising interest rates will lead to poor equity and bond performance. By rotating into commodity-sensitive and cyclical stocks, investor returns could see appreciable outperformance in the coming years.
I think Jeffrey Gundlach, CEO of Doubleline is one the best investors in the world. He is a top institutional bond investor and called major equity market crashes in 2000 and 2008. Jeffrey Gundlach said in 2018 “commodities are very, very cheap. Commodities have long cycles, as well. A fascinating chart [below] has been circulating 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.” We believe this commodity rotation has begun in earnest.
For client accounts we are long natural gas stocks, Master Limited Partnerships, steel, and gold stocks to participate in this rotation to commodities.
Tyson Halsey, CFA