The market had its first down week after a strong rally. Macro concerns are high and there’s no shortage of bears on the street. At the same time, inflation rolling over has proven a strong catalyst. When inflation is high bonds and stocks are positively correlated, which gives institutions nowhere to run and nowhere to hide. When the environment is disinflationary or deflationary the correlation is generally negative. The negative correlation is one of the drivers of the oft cited 60/40 portfolio. And then remember also that there are almost no living portfolio managers that have been alive in an inflationary environment like we face today. Our Head of Research, Tom Lee, thinks that if inflation has peaked that this should set us up for a nice rally in the 2H where new all-time highs are possible. He will elaborate more below.
Mr. Lee points out that the scars from the 2008 Global Financial Crisis may be coloring people’s fears. Markets do tend to climb a wall of worry and inflation was the main thing investors were afraid of. However, the de-anchoring of inflationary expectations that led to the “shock and awe” approach that Paul Volcker famously took with markets in the beginning of the Reagan Administration is not occurring. If the market’s expectations are largely in line with eventual Fed actions, then the type of rapid re-pricing adjustments that can cause unpleasant forced liquidations should be less likely. The character of the decline in 1H 2022 was not one of panicked desperation but rather orderly despite the extreme multiple compression that occurred in stocks with a high proportion of their net present value comprised of future earnings. The pervasive bearishness on the street means that the amount of dry powder on the sidelines is also very high. So, from a risk/reward perspective, our team is convinced that any positive catalysts or resolution of key macro issues could lead to a pretty fierce rally.
We realize this is out of consensus, but we tend to think being out of consensus is a good thing. On the other hand, we still do face a lot of macro risks and the future is always uncertain. Very few people fully anticipated how Asset Backed Securities could become one of the most potent financial contagions in human history in 2007, and there could be similar unforeseen risks in different areas of the markets that could prove the bears right. This is definitely a period of limited visibility and elevated risk for markets right now. However, markets have risen through worse. What about quantitative tightening? Well, based on our conversations with clients we actually hear that a good proportion of the street is well-hedged against this risk. The Fed will begin doubling the assets rolling off its balance sheet in September.
One area to watch, though, is productivity. Gina Martin Adams, Bloomberg’s Intelligence Director of Equity Strategy, did some great analysis on similar periods to 1H2022, even though there is a death of historical precedent. In 1H2022, productivity declined contemporaneously with surging inflation. The historical precedents that do exist suggest this dynamic could be followed by strength in equity markets. The only four periods that experienced a similar dynamic were all in the 1970s except for one event of two consecutive quarters where inflation increased and productivity decreased in 2011. All four of these events seem to suggest that a recovery in productivity presaged stock market strength, even if earnings growth remained subdued. When productivity falls, it’s difficult for companies to keep expanding net income margins. Net income margins have fallen two consecutive quarters on a YoY basis.
The meme stock madness that was so prevalent in January 2021 appeared to make somewhat of a comeback this week and at earlier stages of this rally. Our Head of Quantitative Strategy, Adam Gould, has a great alternative data analysis tool called the “Reddit Alert.” His monitoring of the Reddit message boards suggests that activity is nearing all-time highs and is on track to eclipse them. Generally, the positive retail sentiment on the site has been a contra-indicator. Be sure to check out Mr. Gould’s informative work. We want to remind you that elevated mentions of stocks on the Wall Street Bets forum tend to be bearish. However, we are looking for commonality amongst the stocks that do outperform in the wake of a lot of mentions. Mr. Gould is also working on a portfolio informed by Natural Language Processing and Artificial Intelligence that will be introduced before the end of August. Be sure to keep an eye out for his exciting, and very valuable, insights.
The Russians announced they will soon shut off the gas to Nord Stream again “for repairs”. Fear is building about what the great wounded Bear of Europe will do as winter approaches. German growth, essential to the viability of the entire Euro currency area, is largely dependent on cheap Russia gas. Putin will likely be able to cause a recession in Europe and severely strain European unity in a way not seen since 2012 when the Euro debt crisis was a key catalyst for financial markets. Also, upward pressure on Energy prices might cause inflation numbers to move back upward if they are extreme enough. In the event there is not enough natural gas, many plants may switch to oil. This obviously causes upward price pressure on both crucial energy commodities. The grinding conflict between Russia and Ukraine has taken on a grim character and there doesn’t appear to be a quick resolution in sight. Ukrainians are trying to take the offensive, but they really don’t have the military resources or training in large, combined arms offensive operations. So, for the moment, the conflict is a resource-draining stalemate. Our team is always praying for those suffering from this devastating and tragic conflict.
We are all scouring our resources and doing a lot of work to try to give you the best research available. Our research huddle was lively this last week. We are all checking our cognitive bias and working to understand the theses of others that don’t agree with ours. One thing we always try to avoid at Fundstrat is groupthink. So, while we know it can be frustrating to not have unanimous agreement from our various research heads, we actually believe this is crucial to our mission. We look at the market through different lenses and try to zero in on what the highest probability outcomes are. We hope you all enjoy a safe and happy weekend. Enjoy the summer before it slips away!