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Stimulating Exuberance

The pump is primed. High valuations in nearly every asset class suggest investors see promise everywhere. Of course, unprecedented monetary and fiscal stimulus may contribute modestly to the euphoria. Renewed outbreaks across Europe, South America, and Canada are concerning but are unlikely to break the economic momentum. Seasonality is also a concern, as market mavens extol ‘Sell in May and go away.’ While these concerns are all valid, the helicopter money dropped across the world ensures that the economy and investors need not worry about the immediate environment. Easy credit and exciting new technologies compel the investor while sage investors remember past bubbles and speak of prudent valuations. In this environment, the investor’s burden is as old as investing: how to exit before the music stops. The tune is tactical investing. The question is whether to dance or sit it out.


Neither monetary stimulus nor exciting new technologies will change the narrative in the short run. Keep dancing by rotating equities into less popular tunes where value resides.

Highlights

  • High equity valuations suggest allocation and stock selection is vital.

  • Value and the Developed ex-US Markets offer the best reward to risk.

  • Interest rates provide negative real rates and further losses as rates rise.

  • Credit spreads are too narrow and do not compensate for the risk.

  • Copper’s run may abate as inventory building loses steam.

  • US Dollar strength may continue as higher rates draw investors to the US.


Changing Seasons. A constant of life is that the seasons come and go. The financial markets are not different. The markets change to reflect the new information, and the zeitgeist manifests in the market segment that is the darling of the moment. Depending upon the measure, equity valuations reach rarefied air in the US, which suggests exuberance abounds. Indeed, each sector has its coveted technology that offers the possibility of displacing the staid incumbents. The challenge is that the resplendent future everyone envisions in these technological disrupters appears in the price already.


Each decade has a sector the dominates the discourse and leads investors down the path to untold wealth (exhibit 1). Commodities were the theme of the seventies, which gave way to the Consumer Sectors in the 1980s. Technology defined the latter part of the 1990s until the bubble burst, while Financials and then Energy drove the 2010s. Today, the investor hunger for Technology has brought the sector to a weight that accounts for nearly 30 percent of the market. While profits back this technology exuberance compared to the Tech Bubble of 2000, history shows that the prior decade’s leader is not the leader for the one that will come.


Exhibit 1. United States Equity Sector Weights (%)

Source: Siblis Research, CRM Calculations.


An Energy Renaissance. An urgent challenge is the need to adapt the global energy complex to reduce the impact on the environment. Most investors shunned the sector as a relic of the bygone era when the environmental impact was uncounted in operating costs. On the other hand, the technology sector brims with exuberance as world-changing innovations promise a dramatically different future. The price divergence between the two sectors gives fuel to this argument (exhibit 2). Embodied in one word is the threat to this eventuality: demand.


Information technology requires computers, which require electricity. The continued permeation of technology into our daily lives ensures that energy demand will continue with changes coming to how it is generated, distributed, and consumed. Fossil fuels most assuredly face extinction at some point in the not-too-distant future. The Energy sector will undoubtedly require a pivot to avail itself to more climate-friendly means of energy extraction and distribution. The question is not whether the Energy sector is viable but how change occurs to achieve sustainability. As the most repulsed sector, an opportunity exists for those willing to identify the future energy leaders.

Exhibit 2. Price Ratio of US Information Technology/Energy

Source: IEX Cloud. Total returns from representative ETF. Capital Risk calculations. Higher ratio is Information Technology out-performance.


A Luxurious Necessity. Amazon’s entry into the supermarket segment sent shock-waves through the low-margin business. The incumbents feared further margin compression as the legendary efficiency of Amazon unfurled in their sector. Of course, another stalwart of efficiency, Walmart, entered the fray decades before and compressed their margins. Yet, they survived. Consumer Staples have a similar tailwind to the Energy sector that will lift it: demand and technology, enabling efficiency and augmenting pricing power.


The Consumer Discretionary sector handily beat the Consumer Staples sectors over the prior decade as consumer luxuriated in the trivialities of unnecessary goods (exhibit 3). The Millennial generation is entering their prime household formation years, which require the banal supplies for their offspring and their castles' maintenance. The pending demand increase will intersect with technology to enable more precise marketing and customization of these commoditized products. The result may be a return to the heydays of the 1980s when staples ruled the consumer product market.


Exhibit 3. Price Ratio of US Consumer Discretionary/Consumer Staples

Source: IEX Cloud. Total returns from representative ETF. Capital Risk calculations. Higher ratio is Consumer Discretionary out-performance.


A Distributed Future. An increase in demand for energy or consumer staples will require distribution. While the promise of batteries, wind, and solar is real, getting the energy to the home is not the principal challenge: it is ensuring that an energy network is in place to enable transportation and consistent supply. While Utilities are the unexciting sector at the table, they possess the infrastructure for a future that most assuredly will include electricity distribution. How to generate electricity will change, but who delivers may not, given the vast distribution infrastructure required.


Exhibit 4. Price Ratio of US Health Care/Utilities

Source: IEX Cloud. Total returns from representative ETF. Capital Risk calculations. Higher ratio is Health Care out-performance.


While Health Care has long been impervious to pricing pressure, technology may eventually pressure its enviable margins, even with increased demand from the aging Boomer cohort. In contrast, Utilities may enjoy a renaissance as Energy demand accelerates and the need for more charging stations materializes. Intermediaries in the value chain build business empires. With demand and technology aligned, utilities could enable the distributed future that the cognoscenti envision. Only time will tell whether investments that stimulate growth or investor exuberance will reign.


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