Making Hay Monday - June 12th, 2023
High-level macro-market insights, actionable economic forecasts, and plenty of friendly candor to give you a fighting chance in the day's financial fray.
How Narrow Was My Rally?
“If everyone is thinking alike, then somebody isn’t thinking.” -George S. Patton
It’s hard to find a market pundit who doesn’t concede, often reluctantly, that the U.S. stock market’s present state of narrowness is extraordinary. For perma-bulls, it’s an uncomfortable admission. For those of a bearish persuasion — and that would be yours truly, at least for now — it’s proof positive that their vindication is right around the corner.
Perhaps it’s just my congenitally contrarian disposition, but such unanimity among bulls and bears bothers me. It all seems too obvious. Before I try to challenge this nearly universally held belief, let’s consider the supporting evidence. As you will soon see, it’s considerable, if not downright formidable.
At the March, 2000, peak of the epic tech bubble (the first one), the 10 biggest stocks made up 20% of the Wilshire (a broader index than the S&P, as it is comprised of 3,480 companies vs 500). At the end of May, the top 10 represented almost 26% of the Wilshire.
Presently, just seven companies produced the S&P’s nearly 10% return through May. Excluding those, the S&P is slightly down for the year. (June is a different story, as I’ll soon discuss.)
May saw the worst breadth on record, going back through all the months since 1990 when Bloomberg began tracking this. It exceeded the most extreme reading seen even during the infamous tech bubble. (Thanks to Jesse Felder for that one.)
Per Schwab’s Co-CIO Liz Ann Sonders, only 4% of S&P constituents have made a new 52-week high. Small cap companies have trailed the NASDAQ to a degree only seen during the early-2000 blow-off in large cap tech, and at the start of the lockdowns in 2020.
Clearly, this is an unsustainable situation. What is not so clear pertains to how it gets rectified. Typically, these bad breadths/market halitosis conditions resolve themselves by the highly valued issues getting de-rated (a fancy term for smashed).
Yet, alternatively, it could be a case of the laggards catching up to the leaders. Actually, that’s what’s happened thus far in June. The Russell 2000 small cap index is up a rousing 7% in the first nine days of June (through Friday) while the NASDAQ 100 is up a much more pedestrian 2%.
Of course, a third of a month is not long enough to constitute a major trend or, in this case, trend change. But it is possible that this is a harbinger of things to come.
It wasn’t long ago that many market commentators, including this author, were opining that The Great Rotation was finally occurring. This refers to a big shift of investor capital out of the popular growth names into value stocks.
Last year, value did hold up much better than growth, though both fell. Small stocks typically get hit harder than large cap during bear market years like 2022. But the small cap index declined 22% versus a 33% shellacking for the mega-cap tech-dominated QQQ (however, that was worse than the S&P 500’s 18% slide last year). The large cap value index also hung in there much better than the QQQ last year. Once again, though, it was no picnic, as it tumbled down 20.41%.
It is encouraging for the Great Rotation theme/meme, that the cheapest stocks in the S&P have rarely been this discounted relative to the overall market. Per the venerable money manager GMO — one of the investment world’s best value shops — the cheapest 20% of the S&P 500 is in the bottom 2% of months going all the way back to 1970. In other words, the bargain-priced quintile is valued more conservatively compared to the overall market than in 98% of the months over the last 53 years.
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Quoting GMO’s co-head of asset allocation, Ben Inker, Barron’s ran this factoid in a pro-value article over the weekend:
Based on GMO data, the cheapest 20% of the market normally trades at about a 39% discount to the market, whereas today it is trading at a 53% discount. If that ‘deep value’ group reverted tomorrow to its average valuation discount it would outperform the market by 30%, Inker said.
It's a safe bet the market’s most undervalued 20% is heavily populated by energy stocks. With a nod once again toward my perceptive pal Jesse Felder, he ran the following chart in one of his recent newsletters.
As (hopefully) most Haymaker readers are aware, the free cash flow yield is one of my favorite valuation markers. Much more importantly, it is one of Warren Buffett’s preferred investment measures. It is calculated by dividing the excess cash flow (gross cash flow minus capital spending) a stock or, in this case, a sector generates by its market value. It is essentially equivalent to the cap rate on income-producing real estate. Unquestionably, 14% is a remarkably high level and it’s safe to say that no other segment of the S&P 500 is throwing off that much surplus cash.
The main argument against energy in specific and value stocks in general is that they will fare poorly in recession. Yet, as Ben Inker notes, per Barron’s, that is more myth than reality:
“Growth companies are every bit as likely to disappoint in a recession as value companies are, and that means the value companies aren’t uniquely vulnerable in recessions, everybody is vulnerable in recessions,” Inker said in an interview.
“If we are in a world where a lot of companies are going to be disappointing, that is very likely to be more painful for the growth companies than the value companies because it just hurts more to be a disappointing growth company,” he added. “Value companies have the benefit that nobody expects very much of them.
Next week, we’ll take a look at how likely, or not, a recession is based on the weight of recent economic reports. As a bit of sneak preview, I think headlines like this, from Friday’s New York Times edition, are reflective of a complacency that is both dangerous and misguided.
If Ben Inker is right, value stocks will outperform in a recession, despite that many of them tend to be more economically sensitive. But that’s likely why they have been beaten up so badly over the last year or so. This is ironic since it seems like most of Wall Street is giving up on the recession call. If that seems improbable, consider what happened when the first tech bubble imploded in early 2000: value stocks dramatically outperformed growth issues for the next two years, despite the 2001 recession.
Last week, I listened to an intriguing podcast my close friend Grant Williams recently recorded with one of the smartest men in the investment game: Simplify’s Mike Green. Mike made a number of thought-provoking points, but one that most impressed me is the increasing dominance by no-think investors such as Target Date Retirement funds. This is a topic I’ve written on several times, drawing on the insightful work on Target date funds by StoneX’s Vincent Deluard, another one of my besties. (Yes, I’m blessed to have a long list of them.) In fact, Vincent’s analysis of their rebalancing tendencies caused me to put out a tactical buy on stocks almost exactly a year ago when the S&P was on its heels.
Mike’s overarching point is that because these vehicles continue to receive hefty inflows due to the current near-record low in unemployment, they are persistent buyers. They don’t use any kind of discounted cash-flow calculation that dictates stocks need to be marked down due to higher interest rates. If they’ve got money coming in, they put it to work regardless of dramatically higher rates, combined with elevated valuations, that would cause an active manager to try to buy less expensively. In other words, they are price insensitive.
This, of course, is true of inflows into index funds in general that now dominate the investment landscape. These are truly the whales today and have by far the most influence on the direction of stock prices, at least on a somewhat near-term basis.
But this is where it gets interesting and quite supportive of Ben Inker’s view. Should there be a recession leading to sharply increased unemployment, those target funds will be forced into selling. Since they are heavily exposed, by definition, to the mega-cap tech and quasi-tech (AMZN) names, those will experience the inverse of what they’ve seen in recent years: waves of mechanical selling versus buying. Because value stocks benefited by a much smaller degree due to this phenomenon, they will not be subject to the same intensity of liquidation.
It's a captivating thesis that does resonate with my core belief that if a situation like the narrowness of today’s market can’t continue, it won’t. (Hat tip to Ben Stein’s dad, Herb, for that pearl of wisdom.) Something will come along to upset the apple cart — literally, in this case, since AAPL is a big part of this phenomenon. If so, prepare yourself for the advent of The Great Rotation 2.0.
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Thanks David. Appreciate the bits about the cheapest 20% of the market, being heavily populated by a lot of energy stocks.
But I’m wondering if another large component of that bottom 20% is zombie companies, and other overleveraged companies, whose business models are no longer as valid at 5% FFR?
Retirement will be a big factor in the coming Years and, given the wall of Boomers pulling the Pin, there will be pain...How bad? Your guess is as good as mine!