Happy and Healthy New Year 
Full circle
January 2009, my brother-in-law is staying with us in Florida, medically obliged to lay flat on a bed for several weeks. An 18-month bear has deflated equities 40%, the economy is spiraling down with no bottom in sight. The media are all doom and gloom.
I have little to do except wondering if the equity values I was seeing were only mirages, value traps I sure did not want to fall into. Normally capable to read cycles reasonably well and buy good companies when their equities are in the bargain basement, regardless of the environment, in early 2009 I felt unable to commit much of my cash with such really unusual economic and financial uncertainties. This was not an economic problem, it was a banking and financial crisis.
I needed more certainty on valuations. I needed to really convince myself, objectively that conditions would stabilize.
Befuddled friends were calling, asking, almost begging me for help.
I had always wanted to write, like my dad, and I was curious of this new tool to reach people, blogging.
I launched “News-To-Use”, helping people, first of all myself, weeding out noise, focussing on the most meaningful news and stats and reporting and analysing them objectively. Writing and publishing requires being thorough, rigorous, logical and objective, in rather short supply in 2009.
On March 2, 2009 I posted S&P 500 Valuation Analysis: Near Bottom, introducing the old Rule of 20 designed by Jim Moltz in the 1980s.
On March 3rd, 2009, I posted S&P 500 P/E Ratio at Troughs: A Detailed Analysis of the Past 80 Years with the following conclusion: “Trough valuation analysis shows trough S&P 500 Index levels at 720 using 2009 estimates (which are lower than trailing), with a low probability downside risk to between 516 and 602.”
I then demonstrated that
Using historical absolute PE lows to assess the potential downside to the S&P 500 Index is simplistic and based on superficial, non-rigorous analysis. PE multiples are crude discount factors that need to account for, among many factors, interest rates and/or inflation rates over the forecast periods. The absolute historical lows used by the bears, while strictly accurate, were attained in high inflation periods, not comparable to the present.
Using the Rule of 20 to assess PE multiples takes into account the inflation environment and is thus a better tool to value equities in general.
Using this method, and assuming inflation rates in the 0-2% range, trough PE multiples should be 12-14 times trailing earnings. [Versus the 6-10x range that bears were forecasting].
One reader wrote on March 9: “You bloody fool!”
The bleeding stopped on March 6 at 666 on the S&P 500 Index, at a PE of 12.7x trailing EPS and 14.5 on the Rule of 20 scale.
Here we are, 14 years later, with a PE of 21.9 and a Rule of 20 PE of 27.5, ironically debating how to deal with rising inflation, temporary or not.
Amid this debate, here’s what we know:
- Since 1957, 65 years covering all kinds of economic, financial, geopolitical and social environments, the Rule of 20 PE (actual PE + inflation) has consistently ranged between 15 and 25, with only 2 major exceptions, the late 1990s and now. This time is different? A new paradigm? At your own risk.
- The Rule of 20 uses only trailing, objective data, no subjective forecast.
- The Rule of 20 PE always eventually returns to its 20 mean. At current EPS and inflation levels, that would be 3100, 34% below current levels. Exaggerated? The 2000-2002 bear was -45% from a R20 PE of 27.3 to 20.0 in March 2003. This is not a forecast, only an objective, time-tested measure of risk. Equities can remain overvalued for some time, but not forever. The only forecast is that the R20 PE will, eventually, return to 20.0.
- A return of inflation to the Fed’s 2.0% goal would not entirely erase risk since the R20 PE, at 24.0, would still be 20% overvalued.
- It would thus also need a 20% increase in profits to return to the historical 20.0 mean (also median) where valuation upside (20 to 25 = +25%) equals the valuation downside (20 to 15 = -25%). Thus the neutral, “fair” valuation at a R20 PE of 20.0
What we don’t know:
- When will inflation peak and what are the odds of a return to 2.0% in the next 12 months?
- Can that occur without a meaningful economic slowdown?
- Can we reasonably expect profits to rise 20% if inflation declines so rapidly?
The big inflation debate:
David Rosenberg is firmly in the transitory camp, with “transitory” now loosely defines as an up to 3-year process (!). In support, he calls on the San Fran Fed’s work on inflation sensitivity to Covid-19:
(…) the COVID-sensitive sectors are seeing huge inflation of 5.3% YoY — the trend here was 1.4% before the pandemic. The COVID-insensitive sectors are seeing inflation at 2.5% YoY, which may be up from the trough but is still a touch below the 2.6% pace before the pandemic first hit in early 2020.
The San Fran Fed:
COVID-sensitive components include those categories where either prices or quantities moved in a statistically significant manner at the onset of the pandemic, between February and April 2020. COVID-insensitive components include all other core PCE categories.
Rosenberg’s and others’ point is that Covid-insensitive categories are not seeing much inflation (2.6%), therefore whatever price pressures there are, they are mainly due to temporary demand/supply issues/snags and the eventual return to normality will surely bring inflation on Covid-sensitive categories down to the same moderate range.
However, the chart above shows that inflation on Covid-insensitive categories dropped sharply in early 2020 along with all other categories and kept on dropping throughout 2020, contrary to Covid-sensitive categories. In 2021 however, both broad categories flared up: “sensitives” from 2.0% to 5.3% and the “insensitives” from 1.0% to 2.6%.
The devil is in the details and there are details that Rosenberg and others don’t bother to mention but that shed a different light on the analysis:
- The San Fran Fed analysis covers 124 items, 2/3rd being categorized “sensitive” and 1/3rd “insensitive”.
- The “sensitives” include the usual suspects such as cars and trucks, furniture, apparel and footwear, and many other goods but also services such as domestic, medical or education services, hotels and airfare.
- Among the “insensitives”, rental costs carry the larger weights but we also find insurance, garbage collection, health and life insurance, cable subscriptions and financial services fees among others. Most are services which costs are generally adjusted only once a year, often at the beginning of the year. In addition, we know that the official rent measures always significantly lag real world trends as the BLS explains:
Because rents change rather infrequently, the CPI program collects rent data from each sampled unit every six months. (Price collection is monthly or bimonthly for most other CPI items.) Collecting rent data less frequently allows a much larger sample. The CPI divides each area’s rent sample into six sub-samples called panels. The rents for panel 1 are collected in January and July; panel 2, in February and August, etc.
The slower rise in “insensitives” inflation so far is thus no evidence of a muted underlying overall inflation rate. The next 3-6 months will be more telling although several stats are not encouraging.
The next chart plots MoM CPI-Services (blue) and CPI-Shelter (red). Between 2017 and 2019, monthly services inflation hovered around 0.2%. During the first Covid year, services inflation slowed to the 0.1% range but since February 2021 (remember the once yearly price adjustments) it has sharply accelerated and now ranges between 0.4% and 0.5% monthly or 5-6% annualized.
Services account for 61% of the U.S. CPI with rent measures aggregating 31%, half of CPI-Services. Unlike most goods prices, services prices are adjusted infrequently and are highly sensitive to wages. The next chart shows the relationship between YoY inflation on services, shelter and wages:
Anybody modulating an investment strategy or a monetary policy based on the current subdued inflation on Covid-insensitives would be a bloody fool.
In effect, we have gone full circle. In 2009, investors needed to be convinced that unusually low inflation rates would prevent PE ratios from falling to previous lows reached in high inflation periods. Now, investors either dismiss current high inflation rates as temporary or as inconsequential for equity valuations.
Recent trends and history are not on their side.
I am not forecasting inflation here, only assessing each camp’s analysis and debating the odds. So far, I find that the transitory camp’s arguments are weak, tilted toward hope or wishful thinking rather than thorough objective analysis.
Two of the best macro-analysts I know are Jean-Guy Desjardins, CEO and co-CIO at Fiera Capital (friend and former partner) and Henry McVey, head of Global Macro
& Asset Allocation at KKR. Both have, like many others, significantly raised their inflation forecast for 2022 but both continue to view inflation ease in the second half of the year and in 2023. However, they both expect inflation to rest at a level above the Fed’s 2.0% goal.
Here’s how McVey articulates KKR’s views
Goods and services inflation pressures are converging upward in the near term, building to what we think could be a crescendo by June. As such, we see headline CPI running at five percent in 2022, far above the consensus of 3.6%, and up further from 4.7% in 2021. Drilling down into this change, we would highlight several ‘sticky’ inflation points including: 1) Shelter inflation, which drives about 40% of core CPI, is likely headed considerably higher in coming months; 2) Vehicle price inflation continues to be aggravated by the semiconductor shortage; 3) Inflation pressures are broadening as 24 of the 26 sub-components of CPI are now above the Fed’s two percent threshold; and 4) Workers are quitting their jobs—usually for new ones with higher pay—at an outsized rate that would normally be associated with unemployment of just one to two percent.
(…) we think that a tightening job market and a low inventory situation support our belief that there will be upward pressure on prices during this cycle. Hence, our view remains that this cycle’s reflationary nature will be its defining feature.
KKR sees core CPI peak at 6.4% in Q1’22, average 5.0% in Q2 and quickly decline to 2.6% in Q4 when Goods inflation turns negative YoY, mitigating the 3.7% growth in Core Services prices. Investor sentiment and the Fed’s resolve (!) will be severely tested during the first half. As to the expected disinflation in the second half, time will tell how wages behave if inflation on essentials (food, energy and housing) remain elevated.
Note that KKR’s estimate of Core CPI for 2022, now 4.5%, was 2.75% last October. Price dynamics are fooling even the best as companies, large and small, are seeing enough demand to easily pass on their cost increases. The unusual nature of this inflation cycle is that it is both demand-pulled and cost-pushed, feeding each other amid an economy flushed with liquidity. Can the spiral stop naturally as just about everybody believe? It certainly did not start naturally.
TECHNICALS WATCH
Large caps remain in an uptrend per the S&P 500 13/34–Week EMA Trend:
My favorite technical analysis firm keeps warning about concentration, poor breadth and weak small caps. The Russell 2000 corrected 12.4% between November 8 high and Dec. 20. It is now bouncing against its declining 200-day moving average. Whether or not you care about small caps, they are a large share of equity markets. Apathic investor demand cannot be positive.
NDR’s Volume Demand vs. Volume Supply chart illustrates the worrisome demand/supply trends:
(Ned Davis Research via CMG Wealth)
Micro-micro caps are in big demand however:
A Booming Startup Market Prompts an Investment Rush Early-stage venture capitalists are now investing millions of dollars in companies before they even have a coherent business plan, while a growing number of VCs are saying that we are likely in a bubble.
(…) Investors in 2021 pumped $93 billion into so-called seed-stage and early-stage startups in the U.S. through Dec. 15, a record. That amount compares with $52 billion for all of 2020 and $30 billion in 2016, according to PitchBook Data Inc.
With more money coming in—and the number of new venture-funded startups relatively flat—valuations have surged. The median valuation for the seed- and early-stage companies funded in 2021 was $26 million, up from $16 million in 2020 and $13 million in 2016, according to PitchBook. (…)
The combined valuations of private startups globally has swelled into the trillions of dollars—becoming an enormous investment category. (…)
Sam Altman, former president of startup incubator Y Combinator—which has backed hits like DoorDash and Airbnb Inc. —predicted in a December tweet that venture capital returns this decade “are going to be much worse than those from the 2010s.”
To compete, many venture capitalists say they have spent less time on background checks and other research before investing. (…)
Multiple rounds of funding at a buzzy company can come just weeks apart today, particularly in areas investors deem hot, like cryptocurrency or corporate credit cards. In more sedate times, venture capitalists often encourage companies to raise every nine to 18 months. (…)
Monthly Child-Tax-Credit Payments Cease, Ending Cushion for Family Budgets More than 30 million households started getting the child-tax payment in July, with parents using the money on essentials like groceries and stashing it as emergency savings. Unless Congress acts, that stream of cash is drying up.
SUPPLY MANAGEMENT
- OPEC+ expected to stick with planned Feb output increase, sources say Predicting a mild and short-lived impact on demand from the Omicron coronavirus variant, three sources from the group of oil producers told Reuters on Monday.
Current plans would see it raise its February production target by 400,000 barrels per day (bpd) as it has done each month since mid-2021.
In a technical report seen by Reuters on Sunday, the group downplayed the impact on the oil market from the Omicron variant. (…)
While the group has been raising its targets, its production increases have not kept pace as some members struggle with capacity constraints.
OPEC+ oil producers missed their production targets by 650,000 bpd in November and 730,000 bpd in October, the International Energy Agency (IEA) said last month. (…)
Evergrande shares suspended after report it was told to destroy buildings Chinese media outlet says authorities demanded indebted property company demolish residential complex- Tesla dodges supply woes to deliver record number of vehicles Wall Street forecasts another leap in sales as two new plants set to increase production
Sinovac COVID-19 shot with Pfizer booster less effective against Omicron – study
The Sinovac (SVA.O) two-dose regimen along with the Pfizer (PFE.N) shot produced an antibody response similar to a two-dose mRNA vaccine, according to the study. Antibody levels against Omicron were 6.3-fold lower when compared with the ancestral variant and 2.7-fold lower when compared with Delta.
Akiko Iwasaki, one of the authors of the study, said on Twitter that CoronaVac recipients may need two additional booster doses to achieve protective levels needed against Omicron.
The two-dose Sinovac vaccine alone did not show any detectable neutralization against Omicron, according to the study that analysed plasma samples from 101 participants in the Dominican Republic.
A study from Hong Kong last week said that even three doses of the Sinovac vaccine did not produce enough antibody response against Omicron and that it had to be boosted by a Pfizer-BioNTech shot to achieve “protective levels.”