Rotation and Inflation

Equities, rotation and inflation: Growth stocks versus value.

Rotation

What is happening with inflation right now? So, how does it affect the stock market? Also, what do the stock and bond markets have to say about current and future inflation? And when will the current rotation in the stock market stop its sideways motion?

Chris Perras, CFA®, ChFC®, Chief Investment Officer, addresses these questions and more.

 

 

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Chris Perras: Hey, happy Friday. I’m Chris Perras, chief investment officer at Oak Harvest Financial Group. We are a wealth management and financial advisor in Houston, Texas. Welcome to our June 11th podcast: Keeping you connected to your money. While the S&P 500 is sitting at a marginal new all-time high of 4,240, and we didn’t quite get there the way most people on TV we’re talking about in buying value stocks and buying reopening stocks.

We’ve been led the last two weeks by the growth at any price stocks and the technology sector. I wanted to briefly cover two topics. The first topic is the one of inflation, where it stands, and how does it affect the overall stock market. The second topic is the rotational nature of markets throughout bull markets and how they move from a growth stock bias to a value bias.

First off, I want to commend Goldman Sachs and David Kostin’s team over there for an excellent recent research piece on these two topics. Although we’ve addressed both these topics a number of times throughout this year and last, I plan on using a few of Goldman’s charts and some of their data to continue to hammer home the same message the Oak Harvest Investment team has been discussing for the past few months.

First off on the top, I’ve given inflation. Yes, it has risen since last year in April when the entire world was locked down and in quarantine. No, the investment team at Oak Harvest continues to believe it is not a major issue for the stock markets and returns this year as a great deal of the rise in pricing the last year has been due to shorter-term supply-demand imbalances caused by the shutting down of certain industries and certain services. As we’ve shown for four to six weeks by way of charts and leading edge commodities like lumber, copper, steel, as well as the 10 to 2-year interest rate yield curve and the 10-year breakeven inflation rate, interest rate, inflation momentum peaked in late March and started to decline in or around May 10th through 12th.

The financial markets do not wait around for the government-released CPI data that every economist, every newsletter writer, and every TV analyst was quoting yesterday. If you want an answer to why interest rates rallied yesterday on the worst inflation data in decades, here it is. It’s because they, the bond markets, are smart and they’re forward-looking, not looking in reverse.

As an investor, the question should be, “What happens to the stock market when inflation is high and starting to peak and decline?” Here’s where the Goldman Sachs’ data shines. Since 1962, when core CPI data was high and falling much like it has started to do now, the past four to six weeks, the average market annualized return was a positive 15%, a positive one-five percent. Yes, you heard that, right. A positive 15% contrary to the alarmist headlines on CNBC or other networks. Here is where I digress again to how absurd and misinformative what is deemed a headline in breaking news on the financial news channels.

I think it was on Monday that CNBC picked up the Goldman Sachs research piece and promoted it with the following headlines. I quote, “‘Market returns are much worse when inflation is high,’ Goldman says. Here’s how to play it.” That was their quote. That was CNBC’s leading quote. Now listeners, I want to take you a moment to compare that headline with this one, which is the actual original Goldman Sachs research piece headline and title released over the weekend.

The Goldman Sachs title was this. “Equities and inflation stocks perform better in high and falling inflation regimes than high and rising.” Do those two titles sound anything the same? Does Goldman’s title lead you to believe that CNBC actually even read the Goldman Sachs research piece, or did they just throw up a story to scare listeners and get them to click on their link or watch the next episode? Please, listeners, do yourself a favor and stop watching these trading shows.

This is a prime example of how bad watching financial TV shows are for investors. Well, onto the second topic on this podcast, growth stocks versus value stocks. For the past three to four months, almost everyone on TV has been parroting the same sector allocation theory. What is that? That’s long value overgrowth, long small caps over large, international over domestic. Are the masses ever this correct at the same time after 12 months of a consistent trend? No, almost never.

Once again, it looks like the conventional wisdom is set up to be wrong. The bond market is saying that the now widely period of trade of investors must be long value, not growth trade, was at an extreme measure, and had already started reversing course. The yield curve as measured by the 10-year treasury interest rate minus the 2-year treasury interest rate peaked in mid-March and broke down two to three weeks ago on May 10th to 12th in almost every chart in this world that I can find. We’ve been discussing this dynamic almost weekly, trying to combat the nonstop dire warnings by TV commentators of runaway inflation.

What also started on May 10th to 12th? Well, that’s when growth stocks started outperforming value stocks again. The previous momentum trade of long value stocks and long cyclicals started lagging. Everyone was huddled under the wrong side of the boat in an extreme in sector allocations. Things that lead inflation that trough a year ago in line with our pent-up demand call way back then look like they’ve already peaked.

What are those things? Those are scrap steel, lumber, agriculture commodities. They all look lower, and conversely, what groups are starting to outperform? Yes. You guessed it. The much maligned, large cap technology, bank stocks, biotech stocks, online gaming stocks, secular growth stocks, and even the growth at any price stocks like solar and SaaS stock software had led this week’s furious rally. Pull up any meme stock name, and you will see that it was around May 10th to 12th that all of these names started to accelerate.

That was exactly what about 99% of the TV commentators were out there parroting, the same theme of buy value and buy cyclicals and stay away from growth stocks. In real time, the shape and momentum of the interest rate real curve and the trend and the two components of long-term interest rates, that is the trend in an inflationary component and the trend in the real growth component, gave you the playbook. Didn’t have to watch CNBC and listen to 20 different opinions on it. What you will see is exactly opposite of what you’d been hearing for two months on the TV.

You would see inflation peaking and real growth starting to accelerate. Corn dropped, lumber dropped, copper’s about to break down. Scrap steel, that’s peaking. Wheat down, soybeans down. Are they going to start screaming in about two to four weeks that deflation is around the corner? These are just some of the commodity prices that we follow in real time that give us leading indicators of what should happen in the future.

We are in a secular bull market for equities, and the rotations that are happening happen throughout bull markets, particularly during the summer and particularly in the dead zone of the second quarter, like we currently are sitting in. It just so happened that on Wednesday, Goldman Sachs also put out a piece entitled, “What’s next for growth versus value investing?” Their conclusion was, and I quote, “History, valuations, positioning, and economic deceleration would indicate that most of the rotation from growth to value and most of the outperformance of value is behind us.”

While they do expect value to continue to outperform mildly over the summer, they expect growth stock leadership to pick up in the fourth quarter of 2021 and into 2022. According to Goldman’s, since the financial crisis in 2008, value investing relative outperformance has lasted on average a whopping nine months. Right now, we are seven months into it and counting. Mutual funds are now more overweight value factors than they are growth factors by the most for the first time in eight years. According to Bank America, professional investors are now underweight technology stocks, the most since December, 2018. What happened to the technology stocks starting January, 2019?

I encourage listeners to pull up any chart on the NASDAQ, any chart on FAANG stocks, semiconductors, software, or any other growth stock index post 2018 and look at how well that asset class or sector did relative to the overall market the next 12 to 24 months. What you will see is that time and time again, the herd and consensus thinking, what you hear being parroted on TV or in newsletters, is almost never correct at extremes in financial markets.

1970s inflationary spiral calls. When was the last time that person who said this got a macro call right? Do they manage money? Go ahead and buy gold as inflation hedge calls. Based on what? Does the data say that that has worked at all in the past? Cash is trash calls by hedge fund billionaires. How many times has that person said this the past five years, and what happened in the stock market during the next three to nine months after those calls? Remember, listeners, broadcast TV is no longer mainly true news, it’s almost all opinion.

It’s summer and as far as the team at Oak Harvest is concerned, so far, it’s a very normal one at that. The Oak Harvest projecting for where the S&P five closes year-end of 2021, early 2022, and the S&P hasn’t changed, it remains well over 4,600, which we have been publishing now since pre-presidential election 2020. This is not a stretch by historical standards.

Far from unprecedented, our targets are merely within the statistical average of bull markets. In fact, the board option markets thinks the S&P 500 target can be over 4,800 and possibly approach 5,000 into 2022. The sell-off that we experienced in late first quarter of 2020 is much closer in behavior to the 1987 October stock market crash that merely interrupted an ongoing bull market and did not create a secular bear market or a period of stagnation.

At Oak Harvest, we’re comprehensive wealth management and financial planning advisor located right here in Houston, Texas, give us a call to speak to the advisor. Hopefully, we can help you plan a financial plan in retirement that is independent of the volatility of the stock markets. Give us a call at 281-822-1350. We’re here to help you on your financial journey into and through retirement planning. I’m Chris Perras and have a great weekend.

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