Laying Out The Bullish Case

It may seem a bit odd for me to talk about why someone might buy shares on a day when retail sales in the US were down 1.1%. But that’s what’s been on my mind all morning.

I think the genesis of it is a conversation I had with Jay Pelosky of TPW Investment Management yesterday. Jay is a bull. And he laid out a relatively compelling bull case for me in an interview to air next week on Real Vision. It’s based on rotating out of large cap, technology, growth, non-cyclical and US and into small cap, value, cyclical, and ex-US developed and Asian markets.

So I want to discuss this through two lenses: the first of looking through poor near-term data and the second of thinking more relative value and less about market direction. I am thinking about this as a thought piece, not as advocacy. So let’s run through.

Poor near-term data

Let me get the obvious out of the way; the near-term data is deteriorating at an alarming rate in the US and Europe. And that creates short- to medium-term business bankruptcy and personal income and employment risks that are so deep, they could become long-term in nature.

The US retail sales numbers reported this morning are emblematic of this situation. They fell for a second straight month in November, a casualty of the rollbacks and closures caused by the third big COVID-19 wave in the US. In addition, we have had to fight decreasing household income as stimulus have rolled off.

Month on month, the numbers were -1.1% last month. and October was revised down to  -0.1% month-on-month instead of the +0.3%  previously reported. This was significantly worse than expected, and will likely drive down Q4 GDP growth estimates. The Markit composite PMI came out at 55.7. So we still have room to the downside before a recession.

The overall mix is also emblematic of the varied sector-specific business situations. For the first eleven months of 2020 compared to the first eleven months of 2019, we saw building materials up 13.4%, food and beverage up 11.6%, nonstore retailers up 22.6%. Meanwhile, food services and drinking places were down 19.4%, clothing and clothing accessory stores -28.5%, gasoline stations -16.4%, electronics and appliance stores -14.1%.

These are massive swings. And while the post-vaccine new normal will see a reversion to mean, some businesses won’t be able to bridge that gap. And this is part of where the longer-term risks lie. Moreover, the new normal may see consumer behavior continue to trend in these altered directions, putting stress on these sectors of the economy, especially companies with poor balance sheets and more mediocre business prospects.


So, looking through these data to the post vaccine period is an exercise in risk management. You will need to pick the right parts of the capital structure as well as the companies with better business prospects and better balance sheets. And, we also need to hope governments have the political will to ward off large scale personal income stresses that boomerang negatively back onto business top lines. It’s not simply an exercise in buying the S&P500 and holding, and buying more on the dips. You’re going to have to rotate.

For me, the most fraught part of the rotation trade is the one to cyclicals and value because it’s predicated on an understanding that, with the vaccines, there is light at the end of the tunnel. While we are in a very dark place now, looking forward, it is financials, energy and industrials that have been most hit and can bounce back. A lot of that is priced in though. How much is not clear. But eventually, a sustained cyclical recovery is likely. And that’s what the rotation is all about.

For example, how many loan losses will financials sustain during this credit cycle? And what is their post-vaccine earnings potential? How much are you willing to pay for that? If you buy the ETF and overweight the sector as a rotation play, you can take a bet on the financial sector doing well. But I would prefer to look at individual companies and individual parts of their capital structure rather than indiscriminately rely on a cyclical rotation that may be priced in after a momentous turn in November.

Country Rotation

One place that I have higher conviction is in the rotation out of the US, particularly large cap tech. Just looking at 52-week returns shows you some eye-popping differentials.

  • Nasdaq +43%
  • Small Cap 2000 +19%
  • S&P500 +16%
  • Dow 30 +7%
  • DAX (Germany) Flat
  • CAC 40 (France) -8%
  • FTSE 100 (UK) -13%
  • IBEX 35 (Spain) -16%
  • Euro Stoxx 50 -7%
  • SET (Thailand) -5%
  • Hang Seng (Hong Kong) -5%
  • Nikkei 225 +12%
  • Shanghai +13%
  • KOSPI (S. Korea) +28%

That’s a remarkable dispersion of returns from what has essentially been a global exogenous shock. The Nasdaq stands out as overbought. The Spanish market, dominated by banks, industrials, and energy, stands out as the most savaged. If you think we are headed for a durable recovery anytime soon, you’d want to be overweight France and Spain and underweight the Nasdaq.

What’s interesting is the discrepancy between European market performance and US market performance given the similarly poor COVID-19 policy responses. European markets have fared worse, with the small caps in the US rallying unusually quickly last month to where 12-month returns are almost 20%.And this is with European indices having already traded at a discount to US indices due to their heavy concentration of old economy companies. That’s a relative value pair.

Then, you have South Korea, Japan and Shanghai versus Thailand in Asia. I thought Martin Wolf’s comments on stock markets in the FT were interesting. He said that implied equity risk premia in the US and Japan were low at 4% versus 7% in Germany. No data there for Thailand or South Koreaa. But, you can see a scenario in which Asia EM-ex China outperforms AsiaIn DMs like SOuth Korea, which has vaulted higher and Japan where the equity risk premium is low.

My View

I have great doubts about how well we will get through this last pre-vaccine period economically. And I also have doubts about the bulls case for high nominal GDP growth coming from a rise in both real GDP and inflation. Putting that together, I continue to see near-term residual downside risk for parts of the economy that are not virus-resistant and for comapnies with weak balance sheets due to the potential for a lockdown-induced consumer pullback that today’s retail sales report highlights.

And the longer-term risk comes in part from a cadre of long-term unemployed unable to find jobs as business formation remains low, causing both real GDP growth and inflation to remain more subdued than the bulls believe. I also think that there is more political risk regarding government support for deficit spending than most people assume. To the degree private sector demand falls short, there is no guarantee that governments are politically willing to deficit spend to fill the gap and prevent longer-term impacts of that shortfall.

So, I am not a bull. But I do buy into the rotation trade. We will have not just one or two but three, four or five different effective vaccines to choose from. And we will likely see mass adoption of these vaccines in the developed world by mid-2021. Someone like myself who is middle-aged but reasonably healthy who might be on the fence about the vaccine will move to conviction as the safety is proved and as workplaces, schools, travel and hospitality companies mandate proof that one is vaccinated.

This is going to drive huge pent up demand growth to jump start the economy sometime in mid-2021. That means the rotation is for real. It has already been hugely priced in in the US though. Large cap tech has run up during the pandemic and now small cap is catching up. Energy and financials have seen some nice runs of late too. And all of this is occurring before the economic effects of the third wave are felt in full force.

This makes the US vulnerable to a pullback, and not necessarily worth buying on the pullbacks. By contrast, many markets in Europe have yet to see as a big a run-up. And East Asian EM has handled the crisis impeccably, with regional supply chain deepening offering potential upside benefits to East Asian growth.

For me, this is not a market for wild-eyed bullishness. It’s one for stockpicking and asset allocation. We’ve already seen some massive performance differentials including with the rotation into US small cap. It’s time to rotate again. And mostly, it’s going to be ex-US.

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