Time to Rotate?

361 Capital Market Commentary | May 26th, 2020

It is only fitting that we have a German amusement ride pictured above given how well this large, developed nation has navigated COVID-19. With its case growth rate slowing significantly this month, the German government is now opening up the country, as well as making a significant investment in Lufthansa. As we see similar moves in other major countries, the financial markets continue to be excited for the positive impact of re-openings. With the markets looking toward slightly more normal operating environments, I would expect investors to continue to leave the safety of their outperforming Technology, Healthcare and WFH/COVID defensive stocks and look further into the opportunities of the less expensive, but higher risk Leisure & Travel companies, Banks, Cyclicals and businesses with more leverage on their balance sheets. The difference in returns between these opposing companies has been dramatic for the last several years and has only widened under COVID-19. If there was ever a time for a significant correction in valuations, this could be the time for it.

While the market argues daily over total market valuations, the real money will be made in the valuation shifts under the hood of the market. You can see and feel the pulse of the market daily. Good news is good news, and even bad news is good news. As someone joked last week, Earth could get hit by an asteroid right now and the market would be up that day. With hope that the worst is behind us, and with all the stimulus and liquidity floating around the system, that is the type of market we are in. But if the economy is really moving past COVID-19 and people will be leaving their homes in the second half of this year, then there will be some industry-leading companies that are trading at 25-75% discounts from where they traded in January. This is where the big money in 2020 will be made. It won’t be made getting a few multiple points out of that mega cap FANMANGO stock. (Throwing in Oracle while everyone is WFH.) So, look at broken retail stocks moving higher. Look at industrials and energy scratching higher. Banks are trying, but still have work. Small caps are climbing. Heck even the new COVID-19 capital of the planet, Brazil, is trying to lift its head out of the sand. Good is good, but bad might be better right now. And if not, move all the value investors to interior offices.

China is heating up with Hong Kong threatening stricter controls, but it is not enough to reverse the major equity indexes. Sure, it will make investing in China, Hong Kong and Taiwan more difficult, but we have plenty of other markets in which to invest right now. It seems like a tough game for China to play with Hong Kong. What if the world awakened one day to an empty Hong Kong while on the other side of the world in Ireland, there was born a new city with 3.75 million new, highly valuable people ready to create, innovate and enjoy life without a big cloud over them? It is an interesting thought for a high IP service economy.

Summer has kicked off for a U.S. that is ready to get out of the house. Denver probably looks like many cities these days with more bikes than cars, every golf course full, every ‘For Sale’ house listing getting plenty of foot or online traffic. But our restaurants will open this week to 50% capacity dining which will be interesting. And for the kids, most summer camps look to be closed. Luckily, we have the mountains and the trails to get out and enjoy. Missing an ocean though. I really miss the sea. Wish that were closer and then this would be the most perfect state to live in. Enjoy the summer and think about some ways to rotate your portfolio to spin some more returns out of it.

The businesses in Germany are seeing green shoots…

Expect the rest of the world to follow as their COVID-19 cases and hospitalizations fall toward zero.
Ifo Germany Business Expectations

A good chart from Marko’s team at J.P. Morgan last week…

I know this is very early data, but all of us are watching it closely. Hopefully the data is being helped by the weather, the masks, the cautiousness and keeping the elderly more protected. If we don’t see a local spike in new case growth soon, the screams to open the economies further will be deafening. Watch the hospital data coming out of the Ozark region, given that it has now shifted to the Swedish COVID control model.
R0 during lockdown vs. after lockdown end by US state

The market posted a higher high for Cyclical stocks last week?

And it definitely continued on Monday.
Cyclicals vs. Defensives
(Goldman Sachs)

If this is the beginning of a turn in value vs. growth, the reversal could be massive to correct this 50% drawdown…

Value vs Growth Historical Drawdowns

Flows have been one way out of value/cyclical and into growth…

How much will reverse if the rotation occurs?
Equity fund flows

Dennis DeBusschere is a great thinker and highlights the P/E valuation discrepancy between growth and value…

“Another round of fiscal support and a treatment/cure are critical for a persistent value rotation,” DeBusschere said. “The next two months could be the sweet spot for that trade as a fiscal stimulus is likely before the end of July and the huma-ingenuity trade (vaccine/cure development) remains positive” in Evercore ISI’s view, he wrote.

Value stocks have continued their long period of underperformance against growth peers amid the Covid-19 market uncertainty. The Russell 1000 Growth Index is up 2.5% year-to-date, while its value counterpart is off 20%. Without a macroeconomic turn, the case for value stocks remains weak, Bloomberg Intelligence Chief Equity Strategist Gina Martin Adams said May 15.

If reopenings remain smooth, it reduces the chance that a second wave of Covid-19 will cause significant economic disruption — which in turn boosts the medium-term economic outlook and increases the attractiveness of equities, DeBusschere wrote. It would also reduce credit spreads, causing stocks with lower credit ratings to outperform near-term, he added.

“The P/E spread between the top quintile of historical growth and traditional value stocks is extreme,” DeBusschere wrote. “Investors need to be prepared for a violent move toward value if there is better-than-expected economic news or development of a vaccine.”


Value Trade

Other top value investors are also highlighting the strategy…

Value is indeed out of whack, according to Asness. “If you think the world, particularly for value investors, went nuts very recently after already being terrible for value investors for a long time, you are correct,” he said in the webinar Friday.

“What is the price to book of the top third of expensive stocks divided by the price to book of the bottom one-third of cheap stocks? So the median is about 5.5 — [meaning] throughout history, the median is that expensive stocks sell for 5.5 times more in terms of price-to-book than the cheapest stocks. The current figure is rounding to 12: that’s the highest we’ve ever seen,” said Asness.

His fellow long-struggling value managers are playing defense, as well.

“It’s so extraordinarily cheap,” said John Rogers, co-CEO and chief investment officer of Ariel Investments, during a recent web event. “There are just extraordinary bargains there. I think it’s going to be a violent turn that will give value investors a great opportunity over the next decade.”

David Herro, Harris Associates’ CIO, argued that the underperformance of value has scared away investors. “There’s so much underexposure to these businesses. I don’t know exactly what the catalyst will be – probably some view of the light at the end of the tunnel in terms of economic recovery. But when it does happen, I think it will be to value,” according to Herro, who also spoke during Ariel’s online event.


Unfortunately, investors are not listening and don’t care about value…

Net % Think Value stocks will outperform Growth stocks

Something to keep in mind: We know what happened to the total market the last times that growth trumped value…

The dash towards growth & tech:
Russell Growth/Value ratio’s 14 month RSI right now is among the *HIGHEST* readings ever.
This only happened:
Feb 1980: stocks crashed next month in March 1980
Dec 1999: near end of dot-com bubble
July 2015: stocks crashed next month in Aug 2015

Russell 2000 Growth/Value

Always fun to look at where the mutual fund and hedge fund managers disagree…

Right now, the big outlier is financials where mutual funds love ’em and hedge funds hate ’em.

Hedge funds and mutual funds disagree most on Financials
(Goldman Sachs)

So, earnings estimate cuts are slowing. This should be more favorable for stocks…

Tweet from @EarningsScout

Here is that chart of Brazil lifting its head out of the sand…

iShares MSCI Brazil Capped ETF

If the international stock markets ever want to reverse their underperformance, they have quite a bit of empty ice to the center red line…

US vs World ex-US equities

Gold had a rest day on Monday but the news channels still playing highlight reels from last week…

@LMT978: $GLD in a massive uptrend at 7+ year highs.

SPDR Gold Shares

Interesting chart in the long-term swing moves between S&P 500 Index and gold…

S&P 500 Large Cap Index/Gold

The gate drops and the vacation bookings rip upward…

Demand has soared this month for vacation rentals in pockets of the US, offering hope for booking companies such as Airbnb as well as state governments desperate for tourism tax revenues.

In Florida, the home of Disney World and Miami Beach, vacation homes are opening up in some counties after the state’s governor relaxed lockdowns ahead of the Memorial Day weekend.

New rental bookings had already begun to recovery in early May and are now 90 per cent higher than they were 12 months ago, according to the state’s tourism website. In April, bookings were down more than 80 per cent year on year in the state, creating pent up demand that has exploded with the prospect of restrictions on travel.

Other states, including Georgia and Alabama, have seen similar spikes in new bookings, according to Key Data Dashboard, a software provider of rental figures.


Year-on-year change in new vacation rental bookings in Florida

TSA notes that almost 350,000 travelers flew last week which is another post lock down record…

TSA checkpoint travel numbers for 2020 and 2019

New home sales are showing little COVID-19 weakness…

Tweet from @Econoday

Home buying and selling activity is so great that Redfin is recalling 35% of their furloughed employees…

This past week, Redfin’s home-buying demand moved out of recovery mode and into growth mode, reaching a new peak. For the seven days ended May 17, demand was 16.5% higher than it was before the pandemic, on a seasonally-adjusted basis.

To handle the rapid rise in home-buying demand, Redfin has been bringing staff back from the furlough that was initiated in early April. Of the roughly 1,000 people who went on furlough, we’ve already welcomed approximately 350 Redfin employees back to work.

The strength of the recovery has been surprising. New cases of the coronavirus have certainly tapered from their peaks back in April, but over 20,000 new cases are still being reported daily in the U.S. and last week another 2.4 million workers filed for unemployment benefits. Home-buying demand seems to have been largely unaffected in the face of those headwinds.


Seasonally-Adjusted Homebuyer Demand Index

And the banks are seeing a surge in purchase mortgage activity…

MBA Purchase Index NSA

Housing stocks have recovered and are reflecting this new surge in home buying, construction and remodeling…

iShares U.S. Home Construction ETF

U.S. railcar volumes have not gotten worse but still have plenty of headroom to recover…

Railcar Loadings of Containers

Copper prices also show us a recovery is brewing…

COMEX Copper

And rice prices look downright inflationary…

Maybe some of those March Costco buyers of the 50 lbs bags can flip some of their hoarding.
CBOT Rough Rice Futures

U.S. Farmers need Chinese purchases even more now that the Brazilian currency and economy has taken such a severe beating…

Soyabeans are at the heart of US-Chinese agricultural trading, accounting for almost two-thirds of American exports to China in 2017, prior to the trade war. In January’s US-China phase one trade agreement Beijing pledged to buy at least $80bn of US agricultural products over two years, including $36.5bn in 2020 — $12.5bn more than it spent in 2017.

But so far China has bought just over $3bn, said the American Farm Bureau Federation, which represents US farmers…

“China for now seems to be trying to satisfy all of its demand from Brazil. That’s what we saw last year [too],” said Nick Ristic at Braemar ACM…

For Chinese buyers, there are economic incentives to buy from Brazil. A record Brazilian soyabean harvest of about 125m tonnes, the real’s tumble against the dollar and lower freight rates for bulk commodities have combined to make oilseed imports from the Latin American country to China about 23 per cent cheaper than those of the US.


Chinese buyers eye cheaper Brazilian soybeans

If you are looking for signs of inflation, take a look at what is happening to global insurance pricing…

@SnippetFinance: Covid is causing a sharp hardening of insurance markets around the world. #insurance #stocks #investing #covid

Global Insurance Composite Pricing Change

“Shale companies that emerge from this downturn are likely to act differently than the growth-obsessed frackers of recent years.”

Hmmm, this could be music to the ears of an investor in free cash flow: Cut off the capital investment into the industry, let the supply fall to meet demand, and then ship that free cash flow to investors.

While oil prices have rebounded in recent days and are above $33 a barrel, U.S. output is still poised to fall because companies aren’t drilling enough wells to make up for production declines from existing wells. Shale wells produce a lot of oil and gas early on, but quickly lose steam. Without investing in new wells, many companies’ output would decline by 30% to 50% in just a year, research firm Wood Mackenzie says.

Shale-oil companies have sharply reduced their drilling budgets for the year, with the top 15 by market capitalization slashing spending by an average of 48%, a Wall Street Journal review of company disclosures found. Forty-six independent U.S. producers planned a combined $38 billion in capital investments this year, the lowest dollar amount since 2004, according to Cowen.

“We believe there’s going to be significantly less capital invested in growth in the U.S.,” said Bill Thomas, chief executive officer of leading shale driller EOG Resources Inc., which has reduced its capital budget 46% for the year. It is unlikely U.S. production will reach previrus levels in the next several years, he added.

Since mid-March, operators have idled almost two-thirds of the U.S. rigs that had been drilling for oil, bringing the nation’s oil-rig count to the lowest since July 2009, according to services firm Baker Hughes Co. That all but ensures U.S. production is going to fall, even if companies decide to restart existing wells sooner than expected…

“It is going to accelerate what was happening and what investors were demanding, which is shifting from a grow-it-and-flip-it model to something more sustainable,” said Matt Adams, a portfolio manager for Franklin Templeton, which has about $600 billion in assets under management. “We’ll have a smaller, more rationalized sector.”


The Other Side of the Boom

The future is looking much more difficult for aviation suppliers…

Older planes are a large source of profit for the aviation equipment suppliers as they often operate like a razor/blade business. New planes and parts are priced at low/no margin and future replacement parts are where the manufacturer will make the bulk of their returns. But currently, the older planes are being removed from service first, thus reducing the very profitable spare part needs.
Surge in aircraft retirements

Indoor shopping malls are also under duress. Here is where the biggest Mall in America stands…

The biggest shopping mall in America is delinquent on its $1.4bn mortgage, in an ominous sign of how the pain in US retail is infecting the $500bn market for commercial mortgage-backed securities.

The owner of the Mall of America, a more than 2m square foot complex in Bloomington, Minnesota, that boasts a Nickelodeon Universe indoor theme park and more than 500 stores, missed its mortgage payments in April and May, documents prepared by Wells Fargo and reviewed by the Financial Times showed.

The mall, which was valued at more than $2bn in 2014, closed its doors in response to coronavirus in March and its management has notified Wells Fargo, the servicer overseeing the mortgage, of the hardship brought by the pandemic. It is unclear whether the owner is seeking forbearance on the loan…

Executives at Macerich, which owns stakes in 47 malls across the US, also disclosed on an earnings call last week that the company had so far collected just 18 per cent of the rent it was owed for May.


Not a good survey for Movie Theater owners…


If you live in Colorado and like golf, I know what you were watching on Sunday…

Because we had our annual day of monsoon in the city and snow showers in the mountains, there was no way that you made it onto the course. Now just wait for hockey to fire up.

According to a press release distributed on Monday by Turner Sports, the second edition of The Match, with Tiger Woods and Peyton Manning beating Phil Mickelson and Tom Brady, 1 up, averaged 5.8 million viewers, though it should be noted it appeared on four platforms—TBS, TNT, TruTV and HLN.

Turner said the number is the largest for a golf audience ever on cable, beating out the previous record of 4.9 million for ESPN’s broadcast of the first round of the 2010 Masters, which was Woods’ return from the scandal he experienced in late 2009.

The Match telecast, which raised $20 million for COVID-19 relief organizations, peaked at 6.3 million from 5:45 p.m. to 6 p.m., Eastern time, as the duos played the front nine in stormy weather at the Medalist Golf Club in Hobe Sound, Fla. Woods and Manning got out to an early 3-up lead, but Mickelson and Brady scratched back during the modified alternate-shot back nine to get to within one before falling in near-darkness at 18.

The overnight ratings for the show made it the top TV program of the day, with the golf beating out NASCAR’s Coca-Cola 600 on Fox.


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