Twin Peaks

COVID CASES

STOCK PRICES - NASDAQ

I've got good news and bad news. And we better get used to hearing that this year. Good news for some is bad news for others. It's going to be a bumpy ride for them.

When I see the twin peaks of Covid infection rates and the world's leading stock market, I am not surprised. If the expectations about economic performance continue to improve, the market won't like it. The struggle to hold on to the easy gains of last year has begun. The transfer mechanism at work here is simple. Stock prices, like inflation, are primarily a monetary phenomenon. The Fed's pivot to a more hawkish stance, in part a reflection of their collective anticipation of the benefits of a post-Covid future, is now driving market volatility.

This is the environment I have been looking for - one in which the economy will do better than the market. Last year's buoyancy, driven by the TINA environment seems a distant memory now. Bonds are becoming a toxic element in many portfolios, as the sudden re-rating of inflation expectations is now driving bond prices higher in the absence of Fed manipulation. The elevated PE ratios being sported by the favoured large-cap stocks have, finally, come under attack from rising discount rates as a result. Tech is now a four-letter word.

But lost in all this talk of valuation collapse, markets are also starting to experience an earnings under-shoot. The labour compensation burden for corporations, perenially a source of stability, has suddenly started to soar almost uncontrollably. The combination of an ageing workforce reluctant to participate and the emerging cohort of job-hopping young workers is likely to create a salary surge that will cut profit margins that have so far only benefitted from easy money pandemic policies. Additionally, input cost inflation, from basic commodities and supply-constrained intermediate products, are adding insult to injury to the profit squeeze.

So do we sell everything? Hardly.

The mid-cycle correction looming ahead (happening now?) as a result of the Fed policy shift will eventually prolong the economic expansion. It will be a healthy rebalancing of the share of GDP that the real economy enjoys, at the expense of the financial economy. Along with labour compensation, I see a higher share of income going to the inventory-building elements of business spending. The capital spending intentions, held back by Covid related shortages of materials and labour are significant pent-up sources of economic growth. When combined with the retail sales benefit from rapid personal income improvements, the outlook for a prolonged strong economy has rarely been better.

And as we see with Microsoft - ATVI this morning, the strong balance sheets that dominate the S&P 500 will support a soft landing for equity valuations through increased take-over and buy-back activity.

And what other segments of the stock market are potential beneficiaries? Certainly, the ones that have already held up better in the correction so far. Financials, Commodities, and Industrials have all withstood the violent downdraft in the first few weeks of the year. The abrupt change in relative performance for Materials versus Technology is shown below. The Financials and Industrials look the same.

Materials ETF/Technology ETF

Companies with strong free cash flow generation and reasonable valuations, as opposed to momentum hype, are now starting to dominate market leadership. Small-cap stocks should also do relatively well during Fed tightening cycles and have never been as cheap compared to the market. Finally, foreign markets - yes even the lowly TSX - look poised to outperform this year. Last month, in my trading account, I purged the last of my U.S. holdings and converted the currency to $CAD.

But is it really that easy? As we heard from B of A's survey this morning, institutional investors have dramatically shifted from big tech to financials recently. Those moves may have jumped the gun. Early reads of the current bank earnings have revealed the damaging earnings effects of higher compensation costs. The sharp downdrafts in JPM stock last week and Goldman Sachs this morning are instructive. The companies will benefit from rising rates but will they have to give that benefit back to the workforce, leaving profit estimates overly optimistic?

Savita Subramanian of B of A has pointed out this vulnerability recently, but few analysts have picked up the torch on calling for negative profit surprises. So if the pivot away from growth to value is solely a pavlovian response to rising rates, we could be seeing a risky knee-jerk bet on value in the short term. The Financials, especially, look stretched. Longer-term, the positive benefits will outweigh the cost effects on profits of a stronger real economy. Companies will eventually adjust pricing and the labour intensity of corporate business models will continue to shrink, thus preserving profitability.

But the twin peaks of the pandemic caseloads and growth stock momentum have quickly come into focus. Our friends at the Fed have a monumental task in removing the largest punchbowl of all time. Time to keep a bit of cash on hand just in case they unexpectedly drop it.

Risk Model: 2/5 - Risk Off

The word virus is likely to be replaced by volatility as the most popular 'V-word' this year. During periods of transition between a supportive monetary environment and a healthy self-sustaining real economy expansion, there are always bouts of uncertainty. So far this one looks the same but is it?

The difference this time is the sheer magnitude of the problem that the Fed must solve given their excessive interventionism. Risk premiums have compressed recently as the bond yields started to advance, eliminating any wiggle room for the market to withstand the slightest of valuation challenges from fixed income. The Fed will likely keep a blind eye turned to a declining stock market as long as the Treasury and credit markets do not turn dysfunctional. They seem willing to let the markets do some of the financial condition tightening for them and accept a market correction. And so they should have given the unprecedented asset value inflation they unleashed 7 quarters ago. The "Powell Put" is still well out of the money.

And using measly quarter-point rate hikes from these low levels of rates is like taking a knife to a gunfight when inflation is pushing 7%. I expect the end of QE may soon be replaced by the threat of active balance sheet reduction (QT). The "four hikes" scenario for 22022 that is currently being priced-in is perhaps not enough, as is the paltry 2.5% terminal rate forecast. But having seen the error of its ways in 2018, our Fed-feathered friends may be content to stay behind the suddenly rising curve for now. Whatever they do, the volatility we have been seeing so far this year - at least in the S&P 500 and Nasdaq - may just be a taste of what's to come. Keep your stops tight and don't go out for lunch.

3 Mo VIX