Reflections on the stock market sell-off

Calling the markets turbulent over the last couple weeks is an understatement. Many new investors have not experienced drawdowns this large and based on the numerous emails/DM’s I have received, this seems to be leaving many bewildered, angry and scared. Instead of writing a specific stock recommendation, this week I’ve taken a step back to think about my high-level views of the market and the lessons I have learned as an investor.

Below are six guiding principles which I have found to be true and below each, how I intend to reflect these in my investment decisions.

Quick Recap: Current Market

The stock market is forward looking. We made new all-time highs during the peak of COVID-19 and now, as the economy shows signs of improvement, the stock market is showing signs of weakness.

The reason for this is because coming out of the pandemic is going to put upward pressure on prices (inflation). The bond markets are reflecting this through higher long-term yields on treasuries (as long-term bonds are sold in anticipation of more inflation). As cash flows and rates start to creep higher, this is resulting in (1) a rotation away from companies that don’t make money into companies that do and (2) is leading to a sell-off in equities, as markets expect an end to the accommodative policies of central banks.

Unfortunately for policy makers, you’re caught between a rock and a hard place. As markets price higher inflation in the future, it makes the cost of current (government) debt more expensive. But if policy makers increase interest rates now (to off-set fears of inflation in the future), it increases the chances that we end up risking the economic recovery we’ve only just started to see signs off.

#1 Productive assets yield the highest returns.

Stocks should form largest % of my invested asset base

Over the long run, productive assets yield the highest returns. Stocks are by their very nature, productive assets, as they are literally pieces of a business. Examples of non-productive assets would be Housing, Bonds and Gold. Over time, stocks have outperformed all these other asset classes. Arguably, some stocks are more productive than others (due to the underlying nature of their business), but short of having your own company, stocks are the easiest entry point to a highly productive asset base for the new investor. Resultingly, I believe stocks are the most efficient means of making long term returns.

Real Returns by Asset Class (ref. Puru Saxena)

#2 Revenue Growth is the biggest driver of Stock Performance

Invest in companies with pricing power

What the single most important driver of the price of a stock? You might think it’s metrics like P/E ratios, Profits or even Cash Flows. In fact, the biggest driver of long run stock performance (1990-2009) is Revenue Growth. Intuitively, if a business cannot sustainably sell its product, then everything else goes out the door.

The companies that have a natural advantage will have pricing power and large Total Addressable Markets (TAM). This is what is considered a “business moat”. Margins and Profits are not important in the short term, as if a business can sell its product (at scale), then there will undoubtedly be ways in which it will be able to monetize this in the future. Meanwhile, multiple compression is just the markets way of reflecting herd behaviors as we swing from optimism to pessimism and should not be a consideration for investment decisions (more on this below).

Sources of Stock Price Performance

#3 The long-term market P/E ratio is ~20x which implies a 5% yield

Assume 20x P/E in long term forecasts/price targets

Despite the media headlines around rising long term rates, the market has actually been positively correlated with rising rates over the last decade. This makes sense if you consider that long term yields rising generally reflect a more optimistic view of the future, and therefore, businesses should be doing better (all else being equal).

10 Year Treasury Yields vs Nasdaq since 2016

But there is something more interesting about this relationship. Even in periods where rates have been declining (such as in late 2019), we have not seen widespread multiple expansion. Or in other words, the market has consistently priced between a 10 to 25x earnings multiple on stocks (periods where it rallied above this such as in 2008 and 2020 were skewed as earnings were based on trailing 12 month averages). Another way to look at P/E ratios is as an earnings yield. A 20x P/E ratio reflects a 1/20 Earnings/Price Yield or in other words, a 5% return. So in other words, investors in the stock market already have an implied earnings yield/discount rate which is factored into investments despite what treasury yields are doing, and it’s around 5% (or a 20x multiple). This is the level I will use to model stock price targets in future blog posts.

S&P TTM P/E Ratio

#4 When inflation becomes a problem, you’ll have time to trade it

Don’t rush into inflation/deflation based trades

I was duped into the inflation trade during the on-set of the pandemic, as Central Banks everywhere, started printing massive amounts of money. My analysis was too simple (even though I was able to make a bit of money on my Gold hedges) and since then, Gold has underperformed the rest of the market.

Gold Spot Price

The reason for this is because a critical part of inflation is the Velocity of Money (that’s a measure of how quickly money is circulating in the economy). This is often neglected and hardest to predict. During the onset of the pandemic, we saw the opposite of inflation (deflation). Why? Because people were not able to spend the money they received from governments. Today, even though much of the US is open, we’re yet to see increasing inflation. Why? Because a large proportion of the money being printed doesn’t end up flowing through to ordinary people (it sits with banks who then recycle this money into treasuries). It is this velocity of money that guides inflation expectations and thats extremely difficult to predict.

M2 Velocity vs Inflation Expectations

The second aspect of inflation is its impact on the stock market. Again, this is a more nuanced relationship, as valuations have actually been pretty supported around a 0-4% inflation range. It’s when inflation starts to break outside of these bounds that valuations start to be negatively impacted. This leaves a wide range for inflation before it starts to creep into stock market performance and make a material impact to your portfolio.

US Inflation Rate vs P/E Ratios

My learning here is that inflation is a bit like the monster under the bed. It’s scary and dramatized but frequently misunderstood. When inflation truly becomes a problem, there will be time to trade it and it will be obvious. Until then, better to ignore the media frenzy around it.

#5 The traditional business has a debt problem

Technological disrupters will prevail in most industries. Old fashioned businesses are value traps

When looking at the inflationary/deflationary effects circulating in the economy, I came across an interesting video by Cathie Wood from Ark Invest. She makes some great points about the worrying levels of corporate debt in the economy. Debt to Equity values continue to remain elevated as many companies have taken the last decade to spend money wastefully (through share buy-backs and dividends). Ultimately, they are in for a hard reckoning here as traditional business models in many industries are due to be challenged by technological breakthroughs.

Some of these breakthroughs that I’m looking at are 3D Printing in Manufacturing, Robotics in Logistics, AI in Insurance and E-commerce. The only solution here is that these incumbants will need to re-structure their balance sheets and reduce prices to manage their debt loads but at the same time, will have their business models disrupted by new entrants who are smarter and more tech savvy.

S&P Large Cap Debt

#6 Don’t fight the Fed

Never take the other side of the Fed in any investment class

This is a common saying in the market. The Federal Reserve is the single biggest buyer of assets in the US economy and has an unlimited amount of resource to solve problems (literally, they can just print more money). If at any point in time in modern US economic history you had bet against the Fed, you would have lost.

Historically, the Fed has been able to respond to liquidity crises with ease. In the past, when yields have increased at a rate which has threatened the Government’s ability to maintain its debt load, the Fed has been able to artificially bring yields lower with remarkable efficiency.

Real Yields vs Federal Debt

The Fed is facing an issue right now with regards to long term treasury yields rising. In fact, the Budget Office estimates that a 1% point increase in yields would cost more than 10x the US annual Defense Budget in interest payments over the next 9 years. I don’t know ultimately how this plays out but with such high stakes and given the historical effectiveness of the Fed in getting what it wants, I expect this to be swiftly dealt with as soon as it becomes a meaningful problem. Indeed the Fed is already sitting on $1.5tn in 1-5 year Treasuries (which could be sold for 10yr + Treasuries to bring long term rates lower).

Federal Debt % GDP
Fed Balance Sheet March 2021

Conclusion

Markets can be extremely volatile and I have found it easy to get caught up in the minutae without taking the time to think about the overall objectives and view that I am trying to reflect. I hope by reading these principles you are encouraged to think through your own view of the markets and the lessons you have learnt so as to have a better game plan to handle swings during the trading day.

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