Profit by Avoiding Growth
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I hope you all had a nice Christmas and New Year’s celebrations. Markets were relatively quiet over the holiday period, and I had not planned to release an article until next week. However, with recent market movements, I feel I should address them in a short article this week, keeping you up to date on recent developments as they unfold.
The Federal Reserve (Fed) spooked markets this week when it released the minutes from its December 2021 meeting. The Fed has shifted stance in the last few months. Along with a faster reduction in quantitative easing, it has moved from one/two interest rate rises in 2022, to three or four rises. The first rate hike is now expected in March 2022. In addition to this, the Fed has started to discuss quantitative tightening (QT). The Federal Reserve cited concerns about inflation and the near full employment status as the reasons behind these shifts in policy stance. One Fed official (Bullard), suggested that QT could begin soon after the initial rate hike expected in March 2022. Markets are forward discounting mechanisms and, needless to say, it didn’t like the news as it priced in this more aggressive policy stance.
What is QT
QT is the opposite of Quantitative Easing (QE). QE is when the Fed (or any other central bank) purchases government bonds and mortgage-backed securities. This greases the wheels of the financial system through liquidity (money supply) and assures the markets in times of turmoil (such as March 2020) that the Fed will be there to save them. Through the purchase of such securities, the Fed expands its balance sheet – as buying these bonds means the Fed holds an asset, which pays interest and the principal back over time.
In contrast, QT is where the Fed ‘normalises’ its balance sheet by no longer repurchasing these securities once they mature. If you want to hear it from the horse’s mouth, you can find an explanation from the Fed here.
Here is a simple explanation of QT. The US Government creates three apples every year (each costing $2), which it sells to the Fed and will pay back (with interest – say 33.3% for this example) in one year. The Fed buys these three apples for $6, and the following year, the US government repays the Fed $6 plus interest of $2 for said apples. The Fed now has $8. It goes back to the US government the following year and purchases four apples (since it has $8 and apples are $2 each) this time, and so the cycle continues. This is a basic explanation of QE.
On the other hand, QT means that once the Fed receives its $8 from the US government, it will keep the $8 and will not re-lend it to the government. This obviously reduces money in the government’s pocket. Now multiply the cost of those three apples by 20 billion and you get the monthly purchases by the Fed for the US government’s securities ($120bn) through 2020. So, as the bonds the Fed purchased during its recent QE programme mature, the Fed will keep the money and not reinvest it in more US government bonds, therefore reducing liquidity in the financial system. This is QT.
This reduction in liquidity alongside heightened inflation is creating heightened volatility in the equity markets. The huge amount of inexperienced retail investors which have joined the stock market since March 2020 has magnified this volatility further.
The Bond Market
The news and reaction to the news was a huge surprise. Yields spiked as the Fed minutes were released, after months of continued decline. However, due to already high 2-year yields, the move on the long end did little to shift the yield curve. A rise in rates should usually lead to a succinct rise in yields, and therefore a rise in the yield curve, which suggests an expanding economy. This is the textbook outcome of interest rate rises. However, if the bond market believes the Fed is raising rates too fast, the yield curve would fall, as the market believes the aggressive policies will lead to a slowdown in growth or a recession. What surprised me was that the curve did not decline but remained flat (30yr-2yr spread – see below). Developed economies are highly leveraged and interest rates hikes along with reduced liquidity, I believe, may create an economic slowdown. This is what happened during the last rate hiking cycle. In 2015-2017, following the Financial and European Debt Crises, the Fed began raising rates, before going heavy in 2018, when it increased interest rates at a faster clip and began QT (is this being priced in today). This ended with a stock market correction which forced the Fed to change its tune.
Global debt rose by $20trn in the first six months of 2021, according to the Institute of International Finance, and total debt is now over $300trn (3 times global GDP). If interest rates were to reach 5%, repayments alone would cost $15trn – or one-sixth of global GDP annually. It’s just not possible. The central banks must strike a delicate balance when raising rates due to such excessive debt levels. This is one of the biggest issues with rising interest rates.
Although retail sales are still strong, the ISM manufacturing reading for December fell to 58.7%. This reading is a leading indicator and has an 85% correlation with GDP, so should this number fall below 55% in the coming months, I will begin to reduce risk in the portfolio. Since beginning the Spark, I have stressed that valuations and free cash flow are hugely important during the economic environment we find ourselves in, because such companies can fund themselves as liquidity tightens. This has been proven correct and is even more evident this week.
US 30yr bond yield - 2yr bond yield, source: Bloomberg
Growth stocks will continue to suffer
Growth stocks love easy money and low interest rates, which is why they fell so heavily following the Fed’s minutes publication. Higher interest rates and inflation (along with lower liquidity) cause investors to discount a business’ future revenues and profits at a higher rate, therefore giving them a lower present value today. This means investors aren’t willing to pay sky-high valuations for companies such as Rivian Automotive (RIVN), which does not have any revenue. This was evident in the moves seen in the growth-focused NASDAQ 100 this week. This index fell 5.5% and many highly speculative technology companies made double-digit losses on the day.
In contrast, my growth at a reasonable price (GARP) stocks held up very well. Vertex Pharma finished the week flat, and Micron Technology was up 1% on the day the Fed’s minutes were released. Airtel Africa was down 3.6% on the day after a move to new all-time highs, which is expected as some investors take profits. Discovery was the star outperformer, up 25% due to analyst upgrades surrounding the merger with WarnerBros. ASOS was the one disappointment, down around 7% on the day. I hold a small position in ASOS (1.5% of capital) as the growth story and compressing margins mean there is still negative sentiment toward the stock. I expect this to U-turn by mid-2022 as supply chain issues ease. Overall, the Spark portfolio is up 1.36% year-to-date against -2.5% for the S&P 500 and -5.5% NASDAQ 100. This shows the importance of portfolio diversification and buying stocks at unjustifiably low valuations.
I can see further weakness in the NASDAQ 100 early next week as markets continue to digest the hawkish tilt by the Fed but the NASDAQ may catch a bid late next week, as the ‘buy the dip’ mentality returns. As I have outlined in recent articles, I am weary of the underlying market conditions at present, so will be conservative with my purchases over the coming weeks while significant market weakness persists.
NASDAQ 100 chart - a breakdown through support (378.61) and the trendline could see major downside, source: TradingView
Showing Humility
Humility is one of the most important traits an investor can possess i.e., admitting when you are wrong. This is one of the great challenges in investing. First of all, recognising that you are wrong, and secondly admitting it and taking corrective action. Price action determines sentiment in the short term but does not reflect the opportunity for a stock in the long term. Just because a stock’s price has fallen does not mean that it is a bad stock. As the king of valuing investing Benjamin Graham says, ‘In the short run, the market is a voting machine, and in the long run it is a weighting machine’. This is evident with some stocks that I currently hold. Micron had been falling for seven months, before rising 45%. Discovery had been falling for nine months and has risen 25% this week. The market is not efficient. With this nuance in mind, how do you know if you are wrong? In this, you find one of many intricacies in investing. Objective judgement of your decisions is key to success over the long term.
In my opinion, there are three reasons that you may add to a position if its price has fallen. You could add because you believe the stock is undervalued (such as I did with Airtel), and price action is not fairly reflecting that. I put a large position in Discovery because I believed it was close to its bottom and added to a rising Airtel because momentum was behind the stock, and I didn’t think the price would come down. Secondly, you could scale into a stock (continually add) because you believe it hasn’t bottomed yet, which is my plan for ASOS PLC. This has the advantage of bringing your average cost down as price bottoms out. Finally, you could add because the stock price is down, and you want to cover your embarrassment/losses, even when fundamentals have changed. Money is hard-earned and easily lost, so adding to positions as fundamentals change is foolish and shows no respect for the money in your pocket. This goes hand in hand with not fully analysing a stock before purchasing it. If you don’t know the reason you hold the stock, one downward move in price or negative story will cause you to find a reason to panic sell.
“There is no shame in losing money on a stock. What is shameful is to hold on to a stock, or worse, to buy more of it when the fundamentals are deteriorating”
Learning lessons
With this in mind, I will be keeping a close eye on precious metals over the next week. Given that in recent months markets have been worried about the withdrawal of liquidity and higher interest rates, I believed that any further hawkish shift from the Fed (as we saw this week) would result in yields falling further, as mentioned above. This has not played out - yet.
Precious metals benefit when real bond yields (Yield minus inflation) are negative or falling. They are currently deeply negative, as you can see below, but are no longer falling due to the moves this week in bond yields (mentioned above). US Consumer Price Inflation (CPI) readings are released on Wednesday, so I will closely monitor the movement of gold following this. Should this reading come in high, then the fundamental case to holding precious metals is still intact. If not, I will reduce exposure through the sale of Polymetal International. One mistake I made in my personal portfolio was holding a high exposure to precious metals throughout 2020. Although precious metals performed well until August 2020, they dragged on my portfolio’s performance for the remainder of the year, causing me to underperform the index. I won’t let that happen again. I will remain exposed to precious metals through physical gold (PHGP) and silver (PHSP), as well as Fresnillo (FRES). As I explained in my initial recommendation, precious metals provide good diversification benefits and although real yields may rise, they are still deeply negative, so if the recent yield move reverses, precious metals will boom again.
US 10yr Yield minus inflation - still deeply negative, Source - Bloomberg
Adding to Momentum
As mentioned, analysts have recently upgraded forecasts for Discovery PLC (DISCA) to a buy recommendation, following the approval of the merger with WarnerBros by the EU. This has caused the stock to rerate, and the negative momentum has now reversed. I believe that I have caught the low in DISCA and, notwithstanding a market correction, the trend reversal for DISCA has now begun. I am therefore adding 0.8% of capital to the stock, making it The Spark’s biggest ever position with 7% of capital invested. My average cost has now risen from $23.31 to $24.00. I can see only two risks left for the stock. One, management can’t execute and two, the US opposes the merger. Following the EU’s approval, I see it as unlikely the US will reject the merger, and I also see management’s inability to execute as low risk, which I explained in my original recommendation here.
Actions:
Buying 0.8% in Discovery PLC (DISCA) at $30.06
Send me any questions, let me know your thoughts, or even recommend a stock to analyse by emailing thesparknewsletter@gmail.com
Until next time,
Peter
Performance Year-To-Date: 1.35%
S&P500 YTD: -2.63%
FTSE All-Shares YTD: -1.32%
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.