A Generational Rotation Is Upon Us

Summary

• Value is set to massively outperform Growth.
• As inflation pressure rises, energy/cyclicals/precious metals will be the best performing sectors.
• Inflationary pressure seldom turn on a dime, once the momentum gets going, it hardly stops.
• Investors should be long value sectors with energy being our favorite.
• This idea was discussed in more depth with members of my private investing community, HFI Research. Learn More »

Photo by ThitareeSarmkasat/iStock via Getty Images

I've had a lot of time to think about what I'm about to write in this week's WCTW. The mental clarity I've had over the past year has really allowed me to think through what is going to be taking place. There are times you have to get lucky in investing, and for those of you that have stuck with the value investing principle over the past 3-5 years, you have not been rewarded. But simultaneously, these are the costs we must pay to achieve superior returns in the future.

As I wrote in the MEMO titled, "Nothing's Free." There's no easy ride in investing and seldom do the early winners continue to be winners and losers continue to be losers. The mean reversion of life and investing always finds its way back to you.

What I see on the horizon is a generational rotation. The old outperformers will become persistent underperformers and old underperformers will become persistent outperformers.

I will categorize this into two categories, growth versus value. When you think about growth stocks, think tech, crypto, biotech, etc., and when you think value, think cyclical, energy, precious metals, banks, etc.

Now for those of you that read my write-ups religiously, you will remember this chart below:

This is the chart of growth stocks versus value stocks. The grey line behind the relative performance chart is the inverse US 10-year treasury yield. As Warren Buffett frequently said, interest rates serve as the gravity of finance. As interest rates rise, gravity pull becomes stronger and companies with dismal earnings today will trade at a lower multiple than a company with higher earnings today. The compression or expansion of the multiple is what serves to determine how growth performs versus value stocks.

Hence, why it's important to understand where we are headed with interest rates, because this determines whether or not growth will outperform value or vice versa.

And as you can see from the chart, interest rates have already started to rise. So this gravitational pull is already getting stronger, the question then becomes, when does the equity flow (liquidity) start to reflect this new dynamic we are seeing on the horizon.

This is where the mental clarity part is so crucial. I think as we look ahead, the question is not whether or not this rotation will happen, but when. And figuring out the when requires us to think about the catalysts. In the case of this generational rotation, the question is, what will investors need to see before they get serious about the higher interest rate risk.

In the very near term, higher COVID-19 case counts in countries like India are leading some investors to pause at the thought of rapid inflation and higher interest rates. But as we've seen in the past, COVID case counts are transitory, inflation and higher commodity prices are not. What we are about to witness over the next few months is what I think should be considered the perfect storm in the world of commodities.

As countries embrace the return to normalcy, the higher demand will inevitably translate to higher prices, and thus fuel inflation. You can already see this via inflation expectation.

And inflation expectations are seldom transitory especially not when the global economy is still trying to recover to previous levels. This is the part that I think the investment community is overlooking. What people have been saying for the past few months is that inflation is coming, but it won't last, and I couldn't disagree more. From rising lumber prices to copper prices approaching all-time highs, the higher commodity prices already taking place does not suggest that this inflationary pressure will prove to be transitory.

We are also seeing companies ranging from Procter & Gamble (PG), Coca-Cola (KO), and Berkshire Hathaway (BRK.A) (BRK.B) pointing out that prices have soared, and there continues to be demand for it. And as companies raise prices, they seldom turn around a few months later and say, "Oh, now let's lower prices."

There's also a very important psychological aspect to the idea of inflation. One quote that 13D Research used to always say is, "Inflation is like pregnancy. You can never be a little pregnant." Once companies raise prices to reflect higher costs, they seldom lower the prices. So the higher prices become the new reality whether or not consumers like it or not. And on the consumer end, because they know prices are going higher, there's the psychological effect that I need to purchase it today before it goes even higher, so this brings forward demand.

A great example of this psychological phenomenon is taking place in the US real estate market. US median home prices have soared ~17% y-o-y, and this price increase is largely due to the lack of inventory. As an anecdotal evidence point, in Oahu, there are on average 17 bids per open house, and the average is $30k over the asking price. Think about that for a second here, there are that many competing offers for homes. It's gotten to the point where I am getting unsolicited offers for my house, which I reply with $30 million, take it or leave it.

In essence, everything I just wrote about points to one thing: inflation is coming. And investors in yield vehicles pay attention to the real rates (interest rates - inflation), so if inflation gets too high, interest rates will have to rise or the real rates turn negative. But if inflation starts to soar before interest rates, then the real rates turn more negative, which then pushes investors to seek protection in real assets. That's why gold and precious metals become the safe haven when real rates turn negative, and investors seeking to protect themselves from ever-higher inflation turn to energy because it is the best protected from higher inflation.

And I firmly believe that once this rotation is underway, it will last for years to come. Business cycles seldom turn on a dime and inflationary pressure seldom comes and goes like the mood of a teenager. These things become the new reality the markets have to contend with, and so with that, investors have to be well-positioned.

A generational rotation is coming. Be well-positioned for what's to come.

Analyst’s Disclosure: I am/we are long LONG ENERGY STOCKS NOT DISCLOSED IN THIS ARTICLE. 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.