How do like that for a title!
Let me flesh this out relatively quickly here. It might end up spanning multiple posts as a result. But, yesterday I promised to follow up on thoughts about market volatility and market directional based on a thesis I am working out. This is where I am going to begin that process.
Growth vs value
This whole discussion begins with the concept of growth versus value, where so-called growth stocks have outperformed so-called value stocks over a longer-term time horizon. Over the past two days, there had been an incipient rotation out of growth and into value, with the Russell 2000 running up ahead of the Dow, ahead of the S&P 500, ahead of the Nasdaq. But, today that's all being given back. Why?
My thesis is that the outperformance of growth is an implicit recognition of lower real and nominal GDP growth across a wide swathe of countries and industries. The fact that growth connotes 'momentum' is an outgrowth of the lack of nominal growth in the economy in a world where returns are compressed by a fall in yields.
Put differently, if earnings growth and nominal yields are both simultaneously falling along with nominal GDP growth, you're not going to be able to hit your return bogey. Two percent on your fixed income portfolio and 5% on your equity portfolio doesn't average to 7% returns in a 60-40 portfolio, does it? That's a big problem.
And so, investors are reaching for yield by extending duration and taking on lower quality credits and earnings. That has also incentivized firms to engage in buybacks, to boost EPS when earnings growth flags. That way, corporate insiders can cash out their options, since a rising stock price aligns them with investors chasing returns.
Value stocks lose in this world. 'Value' stocks offer lower top line growth but greater upside relative to intrinsic value over any discrete medium-term time horizon, say five years. If you're investing in a company whose shares are trading at a 40% discount to the net present value of cash flows over the next five years, that's likely to be a 'value' company. And while that margin of error is attractive, top line growth is likely to be weak. Take a sufficiently large basket of these companies and you won't get a 40% discount to NPV. Instead, you'll get closer to NPV on a range of slower growing companies. And you're going to underperform your return benchmark and your return target.
For professional investors, underperforming means getting fired. So, you don't invest in a sufficiently large basket of 'value' stocks in cyclical industries or the financial services sector. If you're an active manager, you skew your investment mix toward momentum stocks in the growth segment of the market like Facebook, Amazon, Apple and Google. After all, since they make up a huge portion of the indices anyway, you're going to underperform your index if you aren't invested there. And that will get you fired too.
Getting long duration
There's a second part here - and it's about duration. I was talking to value investor David Samra about this in an interview I did for Real Vision. He told me that he invests in companies that trade at a large discount to intrinsic value, a measure he sees as the net present value of cash flow over the medium-term. As I said above, that's what value investors do. But, when interest rates are low, the net present value of distant cash flows is relatively more important, because the discount rate of those cash flows is more important. And so, when you are thinking growth versus value the discount rate becomes hugely important.
I would even put it this way: momentum growth stocks are effectively a duration play; they are long-lived assets whose value is backloaded in any discounted cash flow model, where the lion's share of the value comes from cash flows 5, 10 or 20 years out.
Take Nikola Motor Company, for example. They are a publicly-listed electronic component manufacturer for semi-trucks. Think of Nikola as being to the trucking industry what Tesla is to passenger vehicles. In fact, they are tied at the hip since Nikola Tesla is the man from which both companies derive their names. Here's the thing though. Nikola makes no money. It had $36,000 in revenue in the last quarter's earnings. That's not a typo -- thirty-six thousand, not million. But the market cap is north of $15 billion. Why?
You could say Nikola Corporation is a bubble stock. And I would say it's a long duration play. If you want outsized returns in a low rate environment, you need to skew your investment toward longer duration assets. And Nikola is the quintessential long duration asset.
Long duration = secular stagnation
I think it goes without saying that interest rates aren't going to be negative or zero in a robust economy. Can-maker Ball Corporation doesn't sell junk-rated 5-year paper for 2.875% in a gangbusters economic environment. That's the hallmark of a weak economy, where rates are pinned at zero because growth is lacklustre and investors are begging for yield.
So, in essence, you get a fixation on going long duration when the economy is weak. That's where the yield pickup is. And the longest duration play is in equity, in momentum stocks with no present earnings but lots of forward earnings prospects. In effect, momentum = growth and growth = long duration and long duration = secular stagnation. And so - by the transitive property of math - momentum = secular stagnation.
So, interest rates are so low because growth is so weak. And when growth is so weak, earnings growth is weak. And when earnings growth is weak, investment returns are weak. Investors are loading up on the highest growth, highest beta plays because growth is so weak. They are trying to boost returns by investing in those sectors and companies in the market which offer outsized returns in an otherwise lacklustre investment landscape. This has been true ever since the Great Financial Crisis. And it is true even more today now with the pandemic.
Option value time-decay
Now, if you think of all of this from a derivatives market perspective, with low earning or long duration momentum stocks, you're effectively buying a long-dated call option with huge amounts of implied volatility. The premium is huge because of the huge optionality.
The problem is that the time-value decay is also huge. And that can be measured based via the discount rate. If the discount rate goes up, the option value gets crushed. And that's what happens when interest rates rise in a world of secular stagnation.
If there is even a brief interest rate or inflation expectation shock, interest rates go up. And then, the option value of a Nikola or a Tesla goes way, way down. That's a world of huge portfolio rebalancing, equity fund and ETF withdrawals, margin calls, and rising volatility.
It's not necessarily a down market per se. You could see a rotation out of growth into value due to a reflation-associated rise in inflation expectations and rates. That means bear steepening in bond markets and increasing nominal and real GDP growth plus increased earnings growth due to GDP and operating leverage.
But, the (temporary) rate shock could also be one in which growth remains weak, and therefore earnings for both value and growth are reduced. That would be a scenario of rising volatility, lower equity prices and lower bond prices, a perfect storm.
I don't think these rebalancing scenarios are definitely going to happen. But, since they are the pain trade right now as everyone is crowded into what is essentially a bond proxy, long duration play, it makes sense to think about them. The worst case outcome is the one where inflation expectations rise but growth doesn't. That pancakes everything due to losses in bonds, equities, and a reduction in leverage from volatility control strategies and a withdrawal of funds by investors.
I rate the worst case scenario has having a higher probability though than the best case outcome where reflation leads to higher nominal and real GDP that gets translated into much higher earnings due to operating leverage and resumed share repurchases. What's happening on the policy front in DC right now tells you this is a low probability outcome, even as a short-term outcome.
Lastly, I would say that the worst case outcome is pernicious because it can have an impact even if it is short in duration. A spike in expected inflation and a steepening of the yield curve can trigger a mad rush for the exits that swings us from 2nd and third standard deviation long positioning to 2nd and third standard deviation short positions in a heartbeat. That would have knock-on effects regarding liquidity and financial conditions, potentially triggering real economy impacts and Fed intervention.
The long and short here is that the market's recent moves higher may not be a sign of expected gains. It may simply be a manifestation of herding into a long duration play that is an outgrowth of secular stagnation dynamics. Effectively, we're so bearish, we're bullish.
How much longer does this continue without a major hiccup? Not much longer if the economy downshifts aggressively. As usual, September and October are my markers for when the bill comes due. To be continued
"Effectively, we're so bearish, we're bullish." That is a fantastic summary of the apparent disconnect between the real economy and the stock market.
So if we fall off the fiscal cliff what will happen to long-term treasuries?