2021 Q1 Commentary
By Nick Fisher, Portfolio Manager
This quarter has been a wild ride in markets. By just looking at the major indexes (S&P 500 for example) it appears to have been a fairly ordinary, run-of-the-mill quarter. When you look at the sectors and individual names you get a much more turbulent picture, however. This turbulence is important to be aware of and is giving us clues of potential market weakness. Over-valued technology names, excessive leverage in the system and a significant change in inflation expectations foreshadow volatility and necessitate a cautious stance.
Technology Bubble Update & Risk
The poster child for the extreme end of the market madness and what we deem to be a bubble in some technology stocks, has been the ARK Innovation fund. The ARK Innovation fund takes a long-term view around technological innovation and has had some unique thoughts around investing in disruptive and significant technologies. With its 2020 success, ARK has taken on substantial new assets and when a flood of new monies come into any space, valuations rise like the Eiffel tower. As a result, their investing has turned to speculation. In our view their latest research and “price targets” have become outlandish in order to justify their current market position. After being up 4x since the pandemic lows it is down nearly 30% from its highs in February!
I am shocked, but I guess not surprised, that every time the pendulum has swung [to extremes] the best and brightest minds in the business have focused on finding rationalization or an explanation of why the mania of the moment really made sense.
- Robert Kirby “Tirade of a Dinosaur”
As I’ve come to realize, the tech bubble is a symptom of a broader issue. At the center of this issue is a massive amount of leverage in the system. In the absence of a penalty for excessive risk, you have industry players taking on significantly more leverage than if they were responsible for losses: a crisis of incentives.
As a result, in the few months we have witnessed the meltdown of Melvin Capital, Archegos Capital, and now Greensill Capital, all of which were “lent” many multiples of their capital by banking personnel with no skin in the game and significant rewards from the fees associated with these deals. These blowups are having significant impact on the functioning of capital markets. Thus far we have had more than a $10B cost to the Prime Brokers, which includes a $4.7B recent loss to Credit Suisse’s ~$30B of capital.
This is starting to feel like these may not be isolated issues. This does not guarantee trouble ahead, but anecdotally we tend to see these things ramping up toward the end of a cycle.
The troubling thing is to see the narrative in the media which is really missing the issue of excessive leverage. We need some real investigative journalism again. Unfortunately, there don’t appear to be any journalists left.
“Three blow-ups in three months: Archegos, Greensill, and Melvin Capital. What do they have in common? Insane leverage employed to maximize private gain, provided by lenders that can socialize losses.” - Ben Hunt
Inflation
Inflation has definitely reared its head in a meaningful way. And as Warren Buffett has lamented, “The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislature.”
I don’t think anyone needs to look at the CPI data to know that prices are higher, and some are much higher. I was talking to a local home builder and the lumber package for building a new home has more than doubled in the last year. Commodities pretty much across the board are higher.
As I have briefly touched on, we just don’t know if this is a temporary, “transitory” inflation or a more long-lasting, “secular” inflationary regime change. I understand the likely supply chain constraints brought on by the pandemic. On one hand, the unprecedented government fiscal stimulus has found its way into some spending and asset prices. On the other hand, we still have significant labor slack and unemployment that makes sustained inflation difficult.
This is not the first time that market prognosticators have raised the red flag around inflation either. Following the financial crises congress passed a fiscal stimulus bill and many thought it would lead to runaway inflation. And again, with the institution of Quantitative Easing a few years later and then the “lower for longer” interest rate narrative a couple years ago. Each time inflation hawks warned that we were headed for trouble. So, what makes it different today?
Politics aside, markets have come to realize the Federal Reserve and central banks around the world have limitations and their policies have not been very effective. Furthermore, central bank policies may be doing more harm to low and middle-income Americans, but I digress. The current willingness and reliance on fiscal policy is a meaningful difference today. Where we were all in awe of an $800 Billion fiscal stimulus a decade ago, we shrug off the multi-trillion-dollar packages we have instituted and are currently discussing. Call me skeptical, but I have little faith that Congress will be able to show restraint as their constituents have enjoyed the fruits of their labor. Markets around the world seem to accept this new reality and have embraced the “reflation” narrative.
We are constantly monitoring the situation, but our base case assumes we will see record growth coming out of the Pandemic as the economy returns to normal. We will likely see slower growth into 2022 as the economy normalizes. Fiscal policy into 2022 will be very important and will dictate how inflation unfolds. Regardless the Federal Reserve is likely to keep rates low, savers and bond holders be damned!
Portfolios
Today, there is just no compelling reason to own a conventional weighting of US growth stocks, when valuations are so high. Likewise with interest rates so low, bond prices are not all that attractive either. In other words, there’s just not much benefit to bet on disinflation any longer. Moreover, we are likely seeing a secular long-term shift to a more inflationary environment. What has worked over the last 40 years will likely not benefit in the same way. We consequently find ourselves owning what have become known as unconventional assets. These include emerging markets, commodity producers, and small US value stocks.
30 years ago, these asset classes and risk management weren’t unconventional at all, but with US Mega Cap stocks that just keep going up, the rear-view mirror shows nothing but smooth sailing ahead. We take this laissez-faire market sentiment very seriously and we will remain vigilant.
The following chart is from the Rockefeller Global Family Office. As you can see, they significantly reduced their bond and US Large Cap Equities return assumptions over the next 10 years. They also increased their return assumption related to emerging markets and precious metals. This aligns with our current opinions, although is a bit more optimistic.
Our portfolios are very well positioned for the changing environment. As I mentioned in our base case, we could see a pullback in some of these assets as the market digests the economic conditions post-pandemic. We have benefited so substantially over the last 6+ months, it would not be uncommon for some of these assets to “take a break” while market technicals catchup. These rotations can last longer than a few months according to some of the recent data from Verdad Advisors (highlighted in one of our previous notes) and we have yet to see significant institutional monies flow into these areas. As mentioned with the technology bubble, once momentum gets going, we can see valuations expand beyond our conservative and measured expectations.
