Let me begin by saying that this piece is an expansion of a comment I wrote for the following recent piece by Ian Bezek. Ian is a daily SA must-read. I generally agree with his opinions, and minor differences often lead to an explosive debate inside my own head. That's a normal response to high-class analysis.
Ian's second article on a related subject is also worth reading. I don't have much to add to his view that small caps are outperforming because they are largely domestic (as opposed to large multinationals which may face a renewed headwind from the strong dollar) and because financials and industrials are larger parts of small cap indexes. He notes that small caps are expensive, and I totally agree, don't own any at this moment.
The problem of how to get your head around the Trump Rally is probably the number one idea presently on the minds of thoughtful investors. How real is it? Why did it happen? Will it continue? Is it a new bull market? What might provide evidence? What should you do about it?
I don't have exact and final answers. Anyone who appears to have answers should be read with your discounting glasses on. As usual I have a few opinions (also to be heavily discounted) and a suggestion or two for framing the question.
This is my highest conviction view. Anything can happen in the markets, but this doesn't look like a bull market. The blast-off phase of a bull market generally lifts everything, has enormous total volume (often an exponential jump to a whole new scale), and days with winners over losers by 10 to 1.
Nothing remotely like this has happened. In fact, the movement of the total market has been very modest. What has actually happened is that a market with extreme dispersion - virtual bifurcation between popular expensive stocks and hated cheap stocks - has compressed from both ends toward the middle. Value stocks have rallied furiously while growth stocks have hit an air pocket. How should we think about this?
For one thing, the move has been powerful. The negative correlation between growth and value has been high. The past ten days on my SA portfolio list has followed a pattern - value up and growth down, every day, even to the intraday level. Minor corrections in financials have been brief and reluctant. The market just won't let them go down. This pattern may be softening slightly in the last couple of days, but not enough to persuade me that it is over.
Another thing has been noted in a few places but needs to be reiterated strongly: the trend began before the election, and before the market appeared to have any hint of Trump winning. What this suggests to me is that the trend is based on something more fundamental, and was only accelerated by the prospects of Trump policies. This is often the case with major shifts in the market.
What Lit A Fire Under Banks?
Let's start with the obvious. Banks were the cheapest area of the market unless you assumed they were going to be chopped in pieces and tied in knots by hostile regulation. They were the official bad boys of the last crisis. They had to ask permission hat in hand to do anything. Who wanted to own a slow growth industry with those problems? The answer isn't surprising: almost nobody. The current rally suggested that large institutional investors were caught badly underrepresented in financials and had to play heavy-footed catch-up.
The FANG stocks Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX) and Google (NASDAQ:GOOGL) (NASDAQ:GOOG) and bond proxies were the flip side of the disdain for banks. The FANGS were wildly overpriced using even the most optimistic assumptions for PEG rates. They seemed to be among a handful of companies able to grow in a sluggish economy. Bond proxy stocks like consumer staples, utilities, and REITs were the only place you could get a reasonable income. Low rates and a flattish yield curve took away the other opportunities. The bond proxies look safe.
They were not.
The huge dispersion between banks and REITs (the one bond proxy I owned) had to correct itself sooner or later. This was my thinking around July 31 when I flipped my REITs into banks within a little over a week. The timing turned out to be just about perfect. That part of it was luck. I had no idea that the switch would look so good so fast. I just thought the market had a distortion that would eventually correct itself based on valuation and fundamentals. I woke up one morning and said to myself, hey, you've thought this through, this is what you think, the argument holds together on several time frames, so man up, just do it! Once I started doing it I decided to write this SA piece about it.
When the move started to go my way, the main thing I felt was worry about investors who were still steadfast in their faith about bond proxies as income sources. I read many SA articles on the opportunities presented by the "correction." I wasn't sure how far it would go - still am not - but felt that income investors should start thinking carefully about their premise. My heart went out to them. I expressed my view in the last section of this article. The section is entitled "The People I Worry About".
Causation And The Bond Crash
I don't own any bonds except for I Bonds (which don't trade). There's a simple reason. In recent years they have offered worse and worse return with great risk. Risk? Yes. There's a price at which almost anything becomes a good investment, but there's also a price at which almost anything becomes a terrible and risky investment. Bonds had reached that price.
The low absolute yield and the structure of the yield curve were both absolutely terrible for income investors, retirement investors especially, banks, insurance companies, and pension funds. Nobody could get any reasonable return to defease future liabilities. Pension funds had also found creative ways to be unwise in their promises, but the available return from safe fixed income greatly exacerbated the problems generated by stupidity, corruption, and political shenanigans. Banks and insurance companies, like you and me, just plodded along and made the best we could of a bad situation.
It's in the area of the bond crash that I have a nuance of difference with Ian Bezek. Ian thinks it will slow the economy and perhaps impact industries like housing (mortgage rate increase). There is certainly a case for that. On the other hand, while it may hurt some investors and create a drag on some industries, it will help the majority far more. The reappearance of reasonable safe return will provide a place to go for retirees, near retirees, and savers in general. It rewards virtue, which is generally a good thing.
This debate assumes that the new structure of bond rates will hold, that rates will remain at the new level and time structure, or even move further in that direction. I believe that after a correction, rates will likely do that. That being said, I'm not quite ready to normalize my portfolio by buying bonds.
The Trump Effect
Long term moves often begin with a thrust in which everything gets overbought and stays there, daring you to do a wrong move. I remember the broad market blast off in August 1982. I had seen it coming, more or less, but couldn't have guessed the timing. I put a note on my desk saying: DON'T SELL! Another key thing to remember here is that the bank move had gone on sneakily for almost four months before the election blast-off, and the decline of the glitterati had gone on roughly half that long. I don't think the market knew Trump was on the way. I think it was like a rubber band stretched too far in both directions.
The above paragraph is almost verbatim my comment on Ian's article focusing on the bond crash, and he suggested that I use it in as part of a future article. It's really the core of this one.
All the market effects were beginning to turn in the present direction before Trump, so what he mainly did was to put ongoing trends on steroids. He probably accelerated the pace of things that were inevitable in the long run. Hillary would probably have done some of the same things. She wouldn't have cut taxes, but she might have brought foreign corporate earnings home at a low tax rate, and she would have tried to build infrastructure.
The thing is, building infrastructure on a huge scale has been the right economic policy (one man's opinion) for six or seven years, but our government has failed to get its act together and run with it. A fairly likely positive effect of Trump is the leverage he will possess to give fiscally conservative Republicans a kick in the pants (and I should acknowledge that I am myself an ordinarily stodgy old-fashioned Republican). Austrian school economists will probably put out a hit on me for saying it, but we should all hope that he gets Congress to sign off on trillions for infrastructure and not worry much about paying for it.
We don't have a volume problem with money. Money is abundant. We have a velocity problem with money. Infrastructure spending (defense spending too) will rev up some velocity. Fiscal stimulus under current conditions will not likely have untoward effects on bond rates or the inflation rate. The Fed can eat the bonds if necessary. It might even help pull the dollar down a bit. By the time those bonds mature, the economy will be so much larger that my grandkids will wonder why we ever had a doubt. It's approximately the way World War II ended the Great Depression.
Does The New Trend Have Buyable Staying Power?
What investors should note is that this policy implies a huge shift of the economy away from gadgets and diversions to real things. It makes sense that banks and industrials are up, FANG stocks and bond proxies suddenly less appealing. Is the shift still buyable?
I probably wouldn't buy them at this moment. Banks were very cheap three months ago when I was buying. They are obviously much less cheap now. The average pop of the three I bought heavily - Bank of America (NYSE:BAC), Citi (NYSE:C), and JP Morgan (NYSE:JPM) has been roughly 35%. Did they suddenly get overvalued? Maybe, maybe not. They are more expensive than their average prices over the past ten years. But 10 years is so short as to have the risk of recency bias. I bet most of the analysts downgrading banks on a basis of price are in their middle thirties. Back in the late 90s, when these analysts were in high school, banks had much higher PE multiples.
As for me, I'm just not sure. The election changed a few things fundamentally for banks. They will be much less susceptible to regulatory supervision, both in the way they do business and in the way they choose to give back capital to owners. This should be very helpful, at least in the short run. The whole attitude on banks turned on a dime on November 8. They have shaken off the stigma of being the bad boys of capitalism until the next time.
What should you do now? I would wait for the first real correction and use the time to think. You want a real correction, but it should stop at the first Fibonacci, closer to 20% than 40%.
Just to be clear: this doesn't look to me like the kick-off of a bull market like 1982. The market PE then was 7 or 8. It's triple that now. That's too expensive for the beginning of a general bull market. Banks, however, may be another story.
The bank move since the election has been on very large volume, and has had the look of the sort of blast-off that won't let you in. The volume suggests that major investors got caught behind the curve, and the reluctant corrective feints over the past week suggest a desperate underlying bid. There will eventually be a correction, enough to shake out weak holders, but it's worth keeping an open mind about what the recent large move means.
One idiosyncratic position - a large long term position in Wells Fargo (NYSE:WFC) with large embedded capital gains - provided me with some help in thinking about this. I had the Warren Buffett problem, blindsided but reluctant to sell and pay taxes. I de-risked WFC in a couple of stages, selling dividend reinvestment positions that were in the red and a couple of days later writing in-the-money calls with an expiration in 2017. My original thinking and the structure of the calls (strikes of 40 and 41 with the stock around 46) pretty well expressed my view that WFC had sinned badly, but I would be happy to keep it around 41 or less, maybe more if things evolved favorably. Meanwhile I could keep thinking and try to understand how bad the damage was.
The Trump election caused things to evolve favorably more rapidly than I would have thought. The question, of course, is to what degree the more favorable environment for banks took WFC off the hook. Somewhere under 50, I thought, maybe 47, considering I could take a loss on the options and reduce this year's taxes. That would be quite a pop in post-election fair value for this year's major sinner - close to 20%.
Did the rest of the banks get that much more valuable before they even start having higher NIM (Net Interest Margin) from the new steeper yield curve? Food for thought.
If I get a correction encouraging me to dump some Wells Fargo calls, I will have a measure of what I deeply think about the other banks. Having said that, I have told you my total action so far: zero. For what it's worth, the banks don't scare me the way REITs did last July. Maybe I should just hang a post-it note on my computer saying DON'T SELL!
Of course I was 37 when I wrote that reminder for the blast-off of the Reagan bull, and I'm 72 now - old and cautious. I think I'll just plug along doing the small stuff, managing taxes and reconsidering proper valuation for banks now that they are just one of the other stocks. In the end, proper valuation wins. Best guess opinion: they correct a bit, trade flat for a while, then ratchet gradually upward closing their valuation gap to the rest of the market and offering 10% or so a year total return. That's good enough for me.
Disclosure: I am/we are long BAC, JPM, C, WFC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.