Thursday, July 23, 2020

"S&P 500 Is Inverse Of The Economy"

Our readers already know this stuff but it's nice to see it laid out in a more coherent manner than yours truly would likely accomplish.
From Upfina, July 22:
To be a great investor in all cycles, you need to be good at understanding businesses and macroeconomics. This is a macro world and we are all just living in it. Most major asset classes are being driven by one thing: negative real yields. The S&P 500 is often accused of not following the economy. In the prior cycle, sometimes stocks would rally on bad news because it meant more stimulus was coming. This market is on a whole different level. Investors take fiscal and monetary stimulus as a given. Instead, the market rallies on bad economic news because the work from home stocks, the EV stocks, and the online shopping stocks do well. Those stocks control the market. You might be confused why EV stocks do well in this new world. Look no further than Europe’s $2 trillion COVID-19 fiscal stimulus. The EU committed 30% of its recovery fund to address climate concerns. Don’t let a good crisis go to waste.

A cyclical improvement would be a bad thing for the S&P 500, a market cap weighted index. It would cause real rates to rise. The market is paradoxical in the sense that it expects unlimited Fed and fiscal support, but it also doesn’t expect higher rates or inflation. If COVID-19 was to come under control, stimulus could support growth and inflation. We’re not talking hyperinflation, but that’s not necessary to change this market dynamic. Don’t think in such a binary fashion.

A historically moderate shift in rates can make a huge difference. Convexity is important. In other words, as rates have fallen, it has created an even bigger rise in multiples. If growth stocks trade at a 2% premium to the 10 year yield, when the 10 year yield is at 2.5%, the free cash flow yield is 4.5%. When the 10 year yield falls below 1%, the free cash flow yield is 3%. That change correlates with a 50% rise in the multiple as the PE ratio goes from about 20 to about 30. In this case, if value gets a higher free cash flow premium (of 5%), its multiple rises 25%. Low rates are great for growth stocks. Growth trades at a premium when the economy isn’t growing. Every single basis point of growth suddenly comes from market share gains because the economy is stagnant.

Real Yields Are Negative
Negative real yields create an interesting environment where treasuries, precious metals, and growth stocks are rallying. On Tuesday, even the VIX joined in the rally as everything seemed to levitate. The unusual aspect of the S&P 500 in July is that no matter which sector does well, the index always manages to go up. There have been violent sector rotations under the surface as value and growth seem to take turns going up....

Also at Upfina, July 21:
Greater Greed Than 1990s Tech Bubble