Positioning For A Strong 2021 And Better Times Ahead

However, I also show on the 5-year chart where, since mid-May of this year (and especially during a record-breaking November), there has been improving market breadth and a rotation into value, cyclicals, and smaller caps, which is a bullish sign of a healthy market. To illustrate, the chart below zooms in on the past 7 months' comparative performance of those same two ETFs (RZV and RPG), which shows much different relative performance. Since 5/15/20, SmallCap Pure Value has greatly outperformed LargeCap Pure Growth. I think that a new expansionary economic phase is about to launch, and will be fueled by a vaccine rollout, reopening of the economy, unleashing of pent-up demand, an infrastructure spending bill, and higher inflation.

Value vs Growth 7-month chart

Indeed, institutional buyers are back, encouraged by solid Q3 earnings reports, and they are buying the higher-quality stocks (not just the high-flying momentum stocks). The 5-year TIPS breakeven inflation is once again on the rise, now at 1.83%, which is above pre-pandemic levels. Likewise, a 10-year Treasury yield that has been gradually rising for the past four months (from about 0.50% in August to around 0.90% today) implies increasing confidence in economic recovery and rotation from bonds to stocks. Indeed, history suggests the next leg up for stocks will prod Treasury yields to break out to the upside. Furthermore, as credit markets continue to rally with an ongoing US economic recovery, smaller companies should enjoy better business and credit conditions, facilitating a continued mean reversion for small caps. Industrials, Energy, and small caps typically have greater earnings leverage than large-cap Technology, which provides an advantage during an expansionary economic phase. I particularly like the Industrial sector and small caps.

Notably, the Financial sector (primarily regional banks) has long carried the largest weight in the Russell 2000 small-cap benchmark, although Healthcare has taken the mantle this year. By the way, small-cap Tech has been greatly underperforming large-cap Tech (which of course is dominated by the mega-cap dominators) in both price returns and earnings growth essentially since 2014, so perhaps a continuation of this nascent value/cyclical recovery will finally allow the smaller players to play some catch-up.

Going forward, I expect the extreme Value/Growth and Small/Large relative performance divergences will continue to converge and market leadership will broaden, which should be favorable for value, quality, and GARP strategies like Sabrient’s (which were greatly impacted by the trade war), although not to the exclusion of the unstoppable secular-growth industries. In other words, investors should be positioned for both cyclical and secular growth. So, we enhanced our underlying quant model to make it more “all-weather” by developing a proprietary Growth Quality Rank (GQR) and adding it as an alpha factor to give stronger weight to consistency and reliability of earnings growth and thus allow secular-growth stocks to score in our rankings more competitively with cyclical growth, even with less attractive forward valuations. As a result, our newer Baker’s Dozen portfolios launched since December of last year reflect a better balance between secular and cyclical growth and across market caps. Several Tech names became eligible for consideration (and they have been our top performers), and yet our portfolios also remain well-positioned for a continued market broadening and rotation into value, cyclicals, and small caps.

Similarly, BlackRock recently upgraded US equities to overweight, recommending a “barbell” strategy comprising: 1) quality large-cap stocks “riding structural growth trends,” and 2) small-mid caps “geared to a potential cyclical upswing.” Of course, my regular readers know that this is exactly what I have been suggesting in my posts – and what Sabrient has been doing all year in constructing our various portfolios, i.e., a balance between secular and cyclical growers and across market caps.

To illustrate the improvement in relative performance, the table below shows the performance of the live Baker’s Dozen portfolios from their launch dates through current (12/11/20), as well as since the selloff bottom on 3/23/20 (if it was live at that time) and during the past 6 weeks of risk-on rotation, relative to the benchmark SPY.

Bakers Dozen portfolio performances

GDP, global debt, and interest rates:

The BEA’s second estimate of Q3 2020 real GDP growth came in at an annualized +33.1%, which matched the preliminary estimate and remains the largest ever quarterly GDP growth rate. Of course, the consumer spending that supported this surge was largely the result of the trillions in the fiscal and monetary stimulus (aka, the dollar printing press) rather than organic economic activity. M2 money supply indicates 24% more dollars in circulation today than a year ago. Nevertheless, it helped many at-risk businesses survive. Looking ahead, the Atlanta Fed’s GDPNow initial estimate for real GDP growth (seasonally adjusted annual rate) for Q4 2020 is +11.2%, which is much higher than its initial estimate of +2.2% from several weeks ago. On the other hand, the New York Fed’s Nowcast estimate stands at just +2.5% for Q4 2020 and +5.9% for Q1 2021. Evidently, there remains quite a bit of uncertainty and disagreement in the models. No doubt, the economic recovery has been more “K-shaped” than V-shaped in that segments of the economy has been strong (e.g., technology, WFH, online shopping, home building, home improvement) while other segments either have struggled or have been in an outright depression (e.g., oil & gas, commercial real estate, financials, travel & leisure, dining).

Of course, global debt is a big and growing concern. Here are some startling numbers I dug up. According to the Institute for International Finance (IIF), total global debt is expected to hit $277 trillion by the end of the year, which is 365% of global GDP. Of course, GDP has been artificially boosted by money printing, so organic GDP is a good bit lower (and so the debt ratio is even higher). Among the developed markets (aka advanced economies), total debt is around 430% of global GDP, and for emerging markets, it is around 250%. This year alone, as of the end of September, the world added $15 trillion of debt, about half of which is government borrowing. The US, with our apparent embrace of Modern Monetary Theory (MMT) and unlimited money printing, now has federal debt of about $27 trillion, which is $218,450 per taxpayer and 143% of domestic GDP, and our federal budget deficit seems headed to hit $2 trillion deficit in fiscal year 2021.

The IIF estimates the world could reach $360 trillion in total debt by 2030. And here in the US, the Congressional Budget Office says we are headed for a $100 trillion total debt by 2050. The IIF commented that “There is significant uncertainty about how the global economy can deleverage in the future without significant adverse implications for economic activity.” Moreover, none of these debt numbers includes other government liabilities, such as state and municipal pension commitments, which likely will require federal bailouts to fulfill. Of course, this is all quite ominous in the longer term – but unlikely to impact stocks over the next few years.

Interest rates remain historically low, which makes servicing the debt more manageable. The 30-year Treasury yield closed Friday 12/11/20 at 1.63%, while the 10-year T-note is at 0.90%, the 2-year T-note 0.11%, and the 3-month T-bill 0.08%. So, the 3-month/10-year spread has steepened to +82 bps and the 2-10 spread is +79 bps. A rising 10-year Treasury yield implies increasing confidence in economic recovery. Overseas, many countries are still issuing debt with a negative nominal yield, with over $17 trillion of government debt trading at a negative yield. Moreover, most government debt today (including in the US) trades at a negative real yield (after accounting for inflation).

The next FOMC meeting is this week, but it has become a less momentous event given that the Fed has committed to keeping interest rates low through at least 2023. Goldman Sachs predicts the Federal Reserve will not raise interest rates again until 2025, which they say “encourages economic activity by keeping borrowing costs low, but heightens the systemic risks associated with massive personal, corporate and government debt loads.” However, DataTrek observed that although the ratio of corporate debt to GDP is historically high, “aggregate corporate debt to equity market cap is actually very low just now (33% today vs. 68% in 2009),” which means companies can reduce debt simply by issuing stock, especially given an abundance of cheap liquidity and favorable supply/demand dynamics (i.e., the mismatch between high demand and a limited supply of shares).

Both investment grade and high yield bond spreads continue to tighten, with both now at or below their pre-pandemic levels (and continuing to fall). With A-rated or higher 10-year debt available at 1.5% interest, it is almost “free money” for funding expansion, capital upgrades, M&A, or stock buybacks. And the Fed’s financing cost for its $7 trillion balance sheet (mostly under 5 years maturity) is less than 37 bps/year.

Earnings, valuations, gold, and bitcoin:

As for corporate earnings in the US, after a stellar Q3 earnings season, expectations for Q4 continue to rise. And that’s critical because, as DataTrek observed, “…2021 will live or die by earnings growth alone. Interest rates...won’t help now.” FactSet’s consensus estimate for 2021 is now nearly $170/share, which puts the forward P/E multiple on S&P 500 earnings for 2021 at 21.5x. My view is that rather than another correction to bring valuations down further, more likely there will be continued rotation from the liquidity-driven investing of the past several years to earnings-driven investing, which would favor cyclical/value-oriented sectors (e.g., Industrial, Financial, Materials, Energy), and commodity-oriented industries, supported by a weaker dollar. Notably, Wall Street has been raising estimates for these beaten-down industries with the greatest earnings leverage. Furthermore, DataTrek has observed that Wall Street tends to underestimate the improvement in corporate profits after a recession. So, if you overlay the sell-side’s same 9% underestimation for 2010 after the Financial Crisis, 2021 S&P earnings could come in closer to $185/share, which implies a current forward P/E of 19.8x. This leaves further room to the upside, in my view.

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Disclosure: At the time of this writing, among the securities mentioned, the author held long positions in SPY, EEM, ZM, SQ, TTD, BEAM, QDEL, gold, bitcoin, and ether.

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