4Q, 2021: November Nine

Fourth Quarter 2021

January 12, 2021

By Mark Oelschlager, CFA

About a decade ago when televised poker was in its heyday, the World Series of Poker Main Event – the final tournament of the season which included thousands of participants that each anteed up $10,000 to enter – was broadcast on ESPN. The drama played out over many weeks, with a mix of old pros, young upstarts, online players, inexperienced celebrities, and wealthy amateurs vying for the roughly $10 million first-place prize. When the tournament was finally whittled down to nine remaining players, the competition paused, to be continued at a later date in November, which allowed the proper suspense (and hype) to build. This “final table” of players was known as “The November Nine,” out of which the lucky winner would emerge.

In the fourth quarter of 2020 the November 9 Covid-19 vaccine data prompted a shift in the market on that day, as the cards were turned over on Pfizer’s/BioNtech’s candidate. The positive efficacy data led to a strong rally in lowly-valued stocks and shares of companies that had been negatively affected by the pandemic. The Russell 1000 Value Index rose by 4.1% on the day, while the Russell 1000 Growth Index declined by 1.8% - the largest one-day difference between the two on record. If you have been reading our commentaries you know that we have been positioning for this shift ("Is This a Good Time to Invest?", "The Beat Goes On"), and we were actually a little surprised it wasn’t even more powerful. There was another profitable day for value stocks a week later when Moderna revealed its own strong hand on its vaccine. With these developments the market is sensing an economic recovery enabled by the widespread distribution of vaccines in 2021. The change in economic prospects brought on by the vaccine disproportionately benefits the lowly-valued companies, as many of the more-expensive (growth) companies saw their businesses hold up well, or even benefit, during the pandemic. This effect is amplified by the wide dispersion in valuations that we have cited. The rubber band has been stretched, and it was just a matter of time before it snapped back. Even with the strong outperformance by value stocks in the quarter (by about 5 percentage points over growth), dispersions in valuations remain relatively wide, and we believe the gap will continue to close, which should provide a nice tailwind for the value cohort. To be clear, we continue to invest with the long-term in mind.

One of the forces that has helped drive the valuations of growth stocks so high is an accommodative Federal Reserve (the "Fed"). The Fed has gone all-in; it’s not only keeping short-term interest rates low but is vowing to keep them low for a long time, which, along with its purchases of long-term government debt, has driven long rates lower as well. These low interest rates increase the present value of profits that lie far in the future, which disproportionately benefits the stocks of growth companies. There is no guarantee that rates will stay low for many years to come, but the market is pricing many of the growth stocks like they will. We believe this makes such stocks riskier than they normally are.

The Fed’s actions to help stabilize the economy during the pandemic have resulted in a massive expansion of the monetary base. During the 2008 financial crisis such actions by the Fed did not translate to a dramatic acceleration in M2, or the amount of money in circulation. This time it has caused M2 growth to spike, which means that, theoretically, inflation is a risk when velocity of money (the rate at which a dollar moves through the economy) picks up, as it tends to do when an economy heats up. There are all sorts of secular factors that are keeping inflation low, but there is a point at which all this money-printing will affect the value of the dollar (i.e., cause inflation). In 2020 the US Dollar declined by almost 7% against a basket of currencies. Politicians may like this because it makes our exports more attractive to foreign buyers, but the foundation of a strong economy is a strong currency. The Fed consistently acts as if it has the best hand, but we won’t know for sure until its raise is called.

The game right now has the appearance of being self-sustaining and perpetual. The federal government hands out money to provide support for Americans affected by the pandemic. To finance this spending, it issues Treasury bonds and increasingly depends on the Fed to purchase much of the debt, which the Fed can do without limit because it can print as much money as it wants. The Fed’s verbal guidance and its limitless ability to purchase US debt assure the market that rates will stay low, which keeps borrowing costs for the US low. So, the government can continue to spend without the cost spiraling out of control. Meanwhile, the liquidity and low rates help boost stock prices, increasing the wealth of those that are fortunate enough to have such investments. What could go wrong?

As with many of the investment strategies that have come and gone on Wall Street, it is hard to envision what will disrupt this “trade,” and so it gets pushed further and further to extremes. But eventually something does change, and the bluff is called, leaving much damage in its wake. When people study history they tend to register judgments about the decision making of those that were in power at the time. Slavery, the sinking of the Titanic, the Great Depression, the Holocaust, etc. “How could they have let that happen? What could they have been thinking? How could they be that dumb?” The tendency is to view those who made such mistakes as unenlightened, and that poor decisions like that are a thing of the past. We are supposedly much wiser now. But are we? Or is the growing involvement of the Federal Reserve in the US economy and its unprecedented money printing this era’s case study for students 100 years from now? It’s at least worth pondering.

It will be interesting to see over the next several quarters how quickly the Fed reacts if inflation picks up with a strengthening economy. Any sign of policy tightening could be a gut-shot to stocks and bonds, and likely lead to a shift in market leadership.

The runoff election for the two Senate seats in the state of Georgia took place on January 5. Democrats, who have already won control of the White House and House of Representatives, need to win both races to make the Senate 50-50, effectively giving them a majority since they hold the tie-breaking vote. The prospects for this happening appeared dim as of a few weeks ago, but as we write this it appears the Republicans have been rivered and the blue wave is upon us. The stock market tends to prefer divided government but also seems to enjoy loads of government spending, at least in the short run. It won’t be getting the former, but it may get the latter, in addition to other policy changes on the Democrats’ agenda.

Mark Oelschlager, CFA Oelschlager Investments

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