The financial markets are starting to sense we might be heading into a bout of inflation. This has helped out our accounts this quarter. We have written about how value stocks have suffered the last five years versus growth stocks. Let us talk about it just a little more.
Over the last 12 years the proxy most investors use for new economy stocks or growth stocks is the Nasdaq QQQ. It is a basket of 100 stocks that do not include old school energy and bank stocks. If you take the previous highs in these indexes from the last bull market in 2007 (before the financial crisis) and see how they have done going into this quarter, you will see that the QQQ is up 532%, financial stocks are up 11% and energy stocks are down 41%. New tech has been the place to be for the last decade.
During this 14-year time frame the 10-year-treasury bond interest rate has dropped from around 5% to almost 50 basis points (half of one percent). The reason we mention the decline in interest rates is to point out how the financial markets over this last decade have not been concerned about inflation or that GDP growth will be that great. For the most part the bond market got it right. Why does this matter when talking about growth versus value stocks?
The answer is that value stocks have earnings and so many growth stocks do not. Last year a basket of money-losing growth stocks were up over 100 percent. It seemed like the more you lost the better your stock price did. When interest rates are very low and declining, cash flow and earnings don’t matter as much in a discounted cash-flow model compared to PROJECTED earnings growth rates. Wall Street/Silicon Valley seized on this fact and ran with it. Silicon Valley, with the help of Softbank’s billions in venture capital, drove up the value of virtually every money-losing good idea an inventor had.
Whether you lost money was not important. Money is free. Just promise that in 2030 you will finally make money. If interest rates stay very low, the losses you have today don’t matter as much as the gain you promise 10 years from now.
In the last six months interest rates on the 10-year treasury have started to go back up from around 60 basis points to 175 basis points. Since that time the QQQ is up 17 percent. Financial stocks are up 44%. Energy stocks are up 75%. As rates have gone up, the market bid up stocks that have cheap valuations versus stocks that expect rapid growth. If rates continue to go up as we expect, this trend will continue.
To a lot of investors, basing your long-term buy decisions based on the shape of the yield curve today seems crazy. We can appreciate that thinking. That said, we do not write the rules on Wall Street, we just try and profit from them.
We own a lot of large money-center bank stocks, energy stocks and Berkshire Hathaway which is a combination of all the above. If rates continue to rise on the long end of the yield curve, it indicates growth is coming. In that scenario our accounts should continue to outperform growth stocks and the indexes. Why might rates go higher?
The new stimulus bill of $1.9 trillion (not the old trillion-dollar stimulus bill of 2020) is just a staggering number to comprehend. None of this stimulus money is paid for by higher taxes, and we doubt it will be. Around half of the states will have higher tax revenue in 2020 than they did in 2019, despite COVID and yet we are going to throw another $1.9 trillion of stimulus on top of that in 2021. Our leaders are also talking about a 3-trillion-dollar infrastructure bill later this year. At a time when the tax revenues of the states indicate “the patient” is stable, we are going to shoot him up with Narcan, electric paddles and hot water. This economy is going to be crazy hot over the next few years (absent COVID 2.0).
The CRB index of commodities is up over 50 percent since their lows last year. We think that trend will continue. We think food and energy prices will lead the way. At some point in this cycle our Federal Reserve will be forced to choose between funding the federal government’s budget deficits or letting inflation take off. We think they will choose the latter. If you own long-term bonds, you are going to get killed if this scenario plays out. Since August of last year a basket of 10 and 30-year bonds are down 21%. At some point investors will become less complacent about this than they have been so far if rates continue to rise.
There is an old rule of thumb that the price-earnings multiple of the S&P should be 20 minus the inflation rate. With inflation at 2% today that would put the multiple at 18. If you use todays trailing 12- month earnings for the S&P 500, todays PE multiple is around 40. One can argue that those earnings are depressed by COVID and you would be right. That said, the margin for error is narrow. What is in our favor as value investors is that the large stocks with the highest PE multiples are tech stocks. They have driven this multiple up the most. We own two of those, Tesla and Apple. We have also cut back our positions on both of those in the last 12 months. We know they have been great performers for us but we think they are going to have the wind in their face for a while. In a low inflation world Wall Street will pay up for growth. In a rising inflation world, they will not.
One of our leading stocks this quarter is Nucor steel. It is up over 50% year to date. Nucor owns a recycling operation that will benefit when metals prices go up. It also helps that they are the leading steel producer in the USA. They would be a beneficiary of a new infrastructure bill should it occur. It is a strange sight compared to the last 10 years for a steel stock to be beating the tech stocks. We hope that continues with Nucor.
Our last thought has to do with the economy. Before the last stimulus bill, consumer disposable income was at 50-year highs. This number will only go up as people receive more money this month. The Fed and our government have flooded the economy with money. Most everyone will have a vaccine by June 1. This is going to set the stage for some crazy retail-sales numbers in the US this year. We hope to figure out other ways to profit from this pile up of money. If you have any thoughts on this give us a call
at 417-882-5746.
Sincerely
Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR