This week's interesting finds

This week in charts 

The inverse weight of the Energy sector in the S&P 500 is the best and most consistent explanation of the market's P/E.

Will the election result be a catalyst to change the composition of the S&P 500?

1% out of “Growth and Defense” sectors equates to over 3% increase in Cyclical sectors!

Historically, volatility in the stock market is elevated in the months leading up to an election. This is logical, as the markets hate uncertainty. For investors, it’s important to step back, put personal feelings about politics aside, and objectively assess the situation and what it might mean for your personal finances.

Stock market performance leading up to an election has also been a major indicator of the outcome. The performance of the S&P 500 in the three months before votes are cast has predicted 87% of elections since 1928 and 100% since 1984. When returns were positive, the incumbent party wins. If the index suffered losses in the three-month window, the incumbent loses.

Tonight, we leave the party like it’s 1999

Today, U.S. stock valuations are at ridiculous levels against a backdrop of a global pandemic and global recession. U.S. Treasury bonds – typically a reliable counterweight to risky equities in a market sell-off – are the most expensive they’ve been in U.S. history, and very unlikely to provide the hedge that investors have relied upon.

This is the perfect time to look unconventional, just like in 1999. At today’s valuation spreads, the opportunity set is actually even better. And for those portfolios that are essentially benchmark-agnostic, we believe the opportunity set is the best we’ve seen in our working careers.

In 2020, the economy was destroyed by Covid-19; unemployment went from historic lows to historic highs in a matter of weeks. That should have reasonably dampened the market’s optimistic mood. But it didn’t (after the initial shock of March). The current valuation of the S&P 500 is actually higher than it was pre-Covid-19, which is dangerously odd given the sheer amount of uncertainty that exists (e.g., the shape of the economic recovery, the availability and efficacy of a vaccine, the risk of a second wave, U.S. citizens not adopting safety protocols, just to name a few). 

The real worrisome signs, however, are the increasing silly behaviors of a speculative market. Exhibit 7 is a prime example of the aggressive trading activity of retail investors. 

Though relatively calm for over a decade, this past spring awakened their animal spirits: daily trading activity increased nearly seven-fold over three short months. Bankrupted Hertz rallied 896% in May even though its own management team and the SEC said the company was likely worthless. Nikola, an electric truck maker with no actual earnings, no actual revenue, and…it’s true….no actual manufacturing facility to even make trucks, rallied 692% from April to early June. And then there was Tesla, which was bid up to $400 billion in market cap, making it more valuable than 12 established car companies, combined. The “You just don’t get it, GMO” taunts, the justifications, the mental gymnastics, the outrageous growth assumptions one needs to make to rationalize prices…it is all just too eerily reminiscent of 1999.

Americans have saved an extra $1.3 trillion since the pandemic

If household savings had grown in line with the recent pre-pandemic trend, Americans would have socked away about $2.2 trillion since the start of 2019. Instead, cumulative savings over that time period are worth just over $3.5 trillion. The difference—about $1.3 trillion—could pay for 9% of all the consumer spending that happened in 2019.

This savings boom had two basic causes. First, Americans cut their consumption dramatically. Part of what happened was that the higher-income people who were most likely to keep their jobs while working at home were also the people most likely to slash their spending on virus-sensitive categories such as dinners out and trips to the dentist. They were effectively forced to save because it stopped being safe to go out. Meanwhile, companies borrowed aggressively to offset the decline in sales while the government borrowed to offset the decline in tax receipts and pay for additional unemployment and welfare benefits. The net effect was that consumption spending fell almost 20% in the first wave of the pandemic.

Global energy consumption

Below are the IEA’s projections for electricity’s share of final energy consumption if countries stay on their current course (“Stated Policies Scenario”) and if countries meet the Paris Agreement goals (“Sustainable Development Scenario”). Under both scenarios, electricity’s share grows, but even under the Paris Agreement scenario its share is only 31% of total energy consumption by 2040. Under the Stated Policies Scenario it grows from 20% today to 24% by 2040.

Upstream oil investment needed to meet future demand

This week's interesting finds

Tracking the recovery

The recovery in consumer spending, especially in the low-income category, is now positive YoY, even though employment rates in that category are still down 20% YoY.

The slower recovery in consumer spending by the high income group has had a disproportionate impact on the low income workers living in higher income zip codes because the reduction in consumer spending hit businesses in those neighbourhoods hardest. As these businesses lost revenue, they laid off their employees, particularly low-income workers. Nearly 70% of low-wage workers working in the highest-rent ZIP codes lost their jobs, compared with 30% in the lowest-rent ZIP codes.

Consumer spending by income:

The policy efforts to date haven’t led to a rebound in spending at the businesses that lost the most revenue, and as a result, have had a limited impact on the employment rates of low income workers.

Consumer spending by industry:

Percent change in employment by income:

Percent change in employment by industry:

More on the recovery. 

The Q3 US GDP report noted that the downturn as a result of COVID-19 was led by services consumption which is usually the most stable component of GDP and is also seen as lagging in the recovery. Goods consumption is what’s driving the recovery. This shows how incredibly atypical it is and represents a sharp dichotomy in the economy.

From a policy perspective, if you stop imports, the goods recovery will flow through to employment from fixed business investment. But that’s not the case today.

The importance of entry price

Drawdowns over the past three decades.

Source: S&P Global Market Intelligence

Inflation

Inflation was +1.3% year-over-year in August, and +1.4% year-over-year in September. But here is the breakdown. 

A game of musical chairs

Active managers are under severe competitive pressure.  If they don’t perform they will be removed and the money will go to a passive option, or at least an outperforming peer. Therefore their desire to take significant risk away from the benchmark is low.  Active management has become like a game of musical chairs where it makes sense to hover close to the chairs at all times, rather than risk being at the other side of the room when one is pulled away. 

Allied to this defensive behaviour is the closely related problem of increased short-term thinking.  The threat that most active managers face of being fired tomorrow has profound implications for decision making, both for individual managers and their employers.  Is there any purpose in making a long-term investment decision if there is little chance you will be around to witness it come to fruition?  Indeed, making such farsighted decisions may well hasten your departure. 
 
Success in this game is based on the measurement of performance over increasingly contracted time horizons.  Investors in active funds and managers of them consistently talk about results in terms of days, weeks and months.  This is nonsense.  Financial markets are hugely unpredictable and chaotic, and discerning skill is incredibly difficult.  Over short-time horizons it is impossible. 

This week's interesting finds

Business Applications – Timely Gauge of Real GDP

When Covid struck, new business applications collapsed. But then they soared to a record high by a wide margin. New business applications correlate with U.S. real GDP. This is another economic indicator suggesting significant upside, contrary to the pervasive Wall of Worry.

High-Propensity Business Applications are a subset of total business applications, which includes only applications that have a high likelihood of turning into businesses with payrolls. This avoids applications by laid-off gig workers/independent contractors, and is likely the best representation of “true” new business formations.

The surge in new business applications shows spirits remain optimistic, suggesting strengthening business and consumer sentiment.

There is a 73% correlation between high-propensity business applications, and real GDP growth. Why? New business formations are a function of confidence, both business and consumer. From 2007-2019, business applications led real GDP by 3 quarters.

No price too high

Jim Chanos, the founder of hedge fund Kynikos Associates Ltd., is critical of companies that, he says, are increasingly defining themselves not by revenue or earnings, but by the total addressable market they can win. The idea is “how big is what you’re chasing, forgetting for a second that everybody else is chasing those same markets”. An example is Netflix Inc., which has said their total market “is all the people on the planet”. Chanos said he would “go long any of the space companies that have gone public because we know that space is infinite. There’s no price too high to pay.” His remarks sent shares of Virgin Galactic Holdings Inc. up 7% before paring gains after Chanos said he was just joking.

Domestic China back to Normal?

China Hotel RevPAR grew 24% year-over-year last week. While this is exaggerated by the Golden Week, Morgan Stanley estimates that after adjusting for this holiday, year-over-year RevPAR was flat to pre-pandemic levels.

Note: RevPAR is a metric used in the hospitality industry to measure hotel performance. The measurement is calculated by multiplying a hotel's average daily room rate by its occupancy rate.

Rally powered by assets you can’t see or touch

Take all the physical assets owned by all the companies in the S&P 500, all the cars and office buildings and factories and merchandise, then sell them all at cost in one giant sale, and they would generate a net sum that doesn’t even come out to 20% of the index’s $28 trillion value. Much of what’s left comes from things you can’t see or count: algorithms and brands and lists.

Back in 1985, before Silicon Valley came to dominate the ranks of America’s biggest companies, tangible assets tended to be closer to half the market’s value.

The shift picked up after the financial crisis of 2008 and is taking off anew during the Covid-19 lockdown, with the value of intangible-heavy companies like Google and Facebook soaring while smokestack stocks languish. All of which is a source of deep concern for those who worry about things like employment and inequality.

As a result of those gains, S&P 500 members held more than $21 trillion in intangibles at the end of 2018, more than double 2005. That’s 84% of the S&P 500’s market value, the most ever.

Back in the 19th century, capitalism required large physical investments, such as canals, dams and railroads, which in turn created jobs. That’s true to a much smaller extent now.

Economic recoveries that focus more on intangible investments have increasingly been met with slower labor market bounce-backs. 

Difference between market cap weighted and equal weighted performance

Because the S&P 500 is weighted by a company’s market value, the biggest internet firms have overshadowed declines in several sectors this year. This year, the S&P is outpacing a version of the index that gives every stock an equal weighting by nearly 10%, a gap that would be the highest since the late 1990s.

ESG funds under scrutiny

Investors propelled ESG funds to new heights in 2020 and federal agencies are watching. Inflows into ESG funds peaked in 2020. Many of these funds have recently outperformed the markets, but regulators say they may not be all they claim to be. The tension around ESGs has to do with the way that they’re built. This video goes over various strategies for constructing ESG funds and highlights the lack of standardization and common concerns that investors should be aware of. 

This week's interesting finds

 Coming into Focus

In his latest memo, Howard Marks discusses the unusual characteristics of this year’s economy and the impact of COVID-19 related monetary and fiscal policy actions on today’s markets. Below is one excerpt where he discusses the changes in the composition of the stock market and how that compares to the Nifty Fifty.

Today’s leaders are often compared to the Nifty Fifty, but they’re much better companies: larger; faster growing with greater potential for prolonging that growth; capable of higher gross margins (since in many cases there’s no physical cost of production); more dominant in their respective markets (because of scale, greater technological superiority and “lock in,” or impediments to switching solutions); more able to grow without incremental investment (since they don’t require much in the way of factories or working capital to make their products); and possibly valued lower as a multiple of future profits. This argues for a bigger valuation gap and is perhaps the most provocative element in the pro-tech argument. 

Of course, many of the Nifty Fifty didn’t prove to be as powerful as had been thought. Xerox and IBM lost the lead in their markets and experienced financial difficulty; the markets for the products of Kodak and Polaroid disappeared, and they went bankrupt; AIG required a government bailout to avoid bankruptcy; and who’s heard from Simplicity Pattern lately? Today’s tech leaders appear much more powerful and unassailable.

But fifty years ago, the Nifty Fifty appeared impregnable too; people were simply wrong. If you invested in them in 1968, when I first arrived at First National City Bank for a summer job in the investment research department, and held them for five years, you lost almost all your money. The market fell in half in the early 1970s, and the Nifty Fifty declined much more. Why? Because investors hadn’t been sufficiently price-conscious. In fact, in the opinion of the banks (which did much of the institutional investing in those days) they were such good companies that there was “no price too high.” Those last four words are, in my opinion, the essential component in – and the hallmark of – all bubbles. To some extent, we might be seeing them in action today. Certainly no one’s valuing FAAMG on current income or intrinsic value, and perhaps not on an estimate of e.p.s. in any future year, but rather on their potential for growth and increased profitability in the far-off future.

How long does it take to double your money?
 

Source: @jsblokland  

Do Treasuries still offer diversification benefits?

The rise of retail trading.

China's Share in Global Exports

China’s exports rose 9.9% YoY. Leading the global economic recovery,

Photo contest: Winner!

For this quarter's EdgePoint photo contest, we wanted everyone to stay safe with our "socially distanced" theme. Our contributors put their zoom lenses to work by capturing some really far out shots, but we'd like to congratulate Craig Advice for his photo of canoeing on Lake Louise.

 

 

This week's interesting finds

2020 Q3 EdgePoint commentary

Equity commentary: The Certainty of Uncertainty

This quarter, portfolio manager Geoff MacDonald looks at the high price that investors are willing to pay in search of certainty and talks about why investors should crave uncertainty in investing.

Fixed-income commentary: Play your part – the role of fixed income in your portfolio

This quarter, portfolio manager Frank Mullen discusses the changing outlook for fixed income and how you can ensure it plays the right role for you in the future.

This chart shows the attribution of growth in earnings per share over time.

Year-on-year operating EPS growth declined 33% as of Q2 2020. The decline in profit margin accounted for 24% while revenue declined 9.3%.

And here is the attribution of global equity returns.

There are now more ETFs than stocks listed on the NYSE and Nasdaq

South Sea bubble

Hydrogen fuel-cell vehicles don’t create emissions, but producing it can.

Hydrogen announcements are coming thick and fast. This week alone, hydrogen-powered double-decker buses arrived in Aberdeen, Britain’s oil capital; Hyundai delivered seven fuel-cell hauling trucks to Switzerland; and Toyota partnered with Hino to develop its own hydrogen-powered big rigs for the U.S.

What’s the problem? Hydrogen is the most abundant molecule in the universe, but it isn’t present on Earth in its free form. We must first produce it. That can be done cleanly by splitting water into hydrogen and oxygen using renewable electricity from solar and wind power. But the cheaper and more prevalent method is to extract it from natural gas or coal, which emits carbon dioxide and locks us into further exploitation of fossil fuels. Projects touting hydrogen’s green credentials often rely on sequestering waste CO2 from its production, a technology still untested on the scale required.

The availability of clean hydrogen fuel is very limited. There are currently plans for more than 60 gigawatts of green hydrogen production globally, but less than half will be available by 2035. Today, making the hydrogen gas generates more carbon emissions globally than the airline industry, according to Bank of America.

This week's interesting finds

History of market bubbles

Source: @jsblokland

The US outperformance vs. other markets appears to be stretched

Source: BofA Global Research, @barnejek

FAANGs Risk Ending Up Like the Nifty Fifty

FAANGs have done very well, along with the rest of the technology elite. The Nasdaq 100 is up 30.5% this year, versus roughly 4% for the broad market S&P 500.

Nevertheless, at some point they risk turning out like the Nifty Fifty did. These were a collection of blue-chip, large-cap names that investors of the day labeled “one-decision stocks.” In other words, they tended to go up like helium, so one should automatically buy them as a sure thing. Sound familiar?

Eventually, a bunch of the Fifty tanked, with 20% in big trouble. They foundered in the vicious 1973-74 bear market and staggered through the stagflation 1970s. A number of its top performers back in the day are desiccated versions of their former selves, such as Eastman Kodak, Xerox, and Sears Roebuck, or are defunct, like ITT and Burroughs. Some, of course, are still in a strong position, notably Walmart.

A similar fate for the FAANGs would cleanse the equity market. That monumental a failure “would do a lot to sterilize the successful ones.”

Number of stocks up at least 400% at some point in the first nine months of each year

At their individual peaks in 2020, more than 60 stocks in the tech-heavy Nasdaq Composite had risen at least 400%. But the gap between the star performers and the losers is wide. Of the roughly 2,500 stocks in the index, more than 1,000 suffered declines of at least 50% for the year at their low points.

The S&P 500’s information-technology sector has the biggest weighting in the stock-market index than at any time since 2000. Meanwhile, financials and energy companies have steadily dwindled to the lowest levels since at least 1990.

Uneven Recovery of U.S. Small Businesses

In the U.S. as a whole, data suggests that nearly a quarter of all small businesses remain closed. Of course, the situation on the ground differs from place to place. Here’s how cities around the country are doing, sorted by percentage of small businesses closed as of September 2020:

This week's interesting finds

What Currency Devaluation Looks Like

This chart shows 10-year Treasury yields (blue line) vs the inflation-adjusted annualized return of 10-year Treasuries bought that year and held to maturity (orange bars):

Data Sources: Robert Shiller, Aswath Damodaran

During the 1940’s, the war period of massive fiscal spending, the Fed capped rates below the prevailing inflation rate. Inflation was transient, coming in spikes, and yet rates were capped at 2.5% or below:

Data Sources: Robert Shiller, Aswath Damodaran

As a result, here’s what happened to anyone who bought and held 10-year Treasuries to maturity from the early 1940’s. Those Treasuries were paid back nominally, but a full third of their purchasing power was lost due to inflation of both the money supply and consumer prices.

Data Sources: Robert Shiller, Aswath Damodaran

CalPERS assumed plan return U.S. 10-Year and 30-year Treasury Note Yield

CalPERS’ (California Public Employees' Retirement System) assumed plan returns going back 60 years compared to the U.S. 10-Year Treasury Note Yield. Back in 1960, the 10-Year was at 4%, and the planned return was 4%, so there's basically no risk premium. In 1981, the 10-Year was yielding about 14%, and the planned returns were 8%. So there was a -6% risk premium. You could have basically locked up a lot of your returns for some period of time. And then now the 10-Years is 70 basis points, roughly speaking, and the planned returns are 7%. Which doesn't seem crazy, but let's call it roughly almost a 6% point equity risk premium. So we've gone from -6% to 6% risk premium. Now you're the chief investment officer in one of these big pension funds, and you're like, "How am I going to get there?"

Sounding good or Doing good?

ESG (Environmental, Social and Governance), a measure of the environment and social impact of companies, has become one of the fastest growing movements in business and investing, and this time, the sales pitch is wider and deeper. Companies that improve their social goodness standing will not only become more profitable and valuable over time, we are told, but they will also advance society's best interests, thus resolving one of the fundamental conflicts of private enterprise, while also enriching investors.

Any attempts to measure environment and social goodness face two challenges.

• The first is that much of social impact is qualitative, and developing a numerical value for that impact is difficult to do.

• The second is even trickier, which is that there is little consensus on what social impacts to measure, and the weights to assign to them.

There are multiple services now that measure ESG at companies, but the lack of clarity and consensus results in the companies being ranked very differently by different services shows up in low correlations across the ESG services on ESG scores:

This low correlation often occurs even on high profile companies: