Eye on the Markets - 2020


Markets Looking Past the Near-Term

By Ketu Desai

November saw a historic rally driven by clarity on many issues that have been plaguing the market for the last couple of months. Despite the rally, the near-term looks challenging from an economic perspective. Higher COVID cases and increasing restrictions make the near-term challenging. We are already seeing this in the data, including weakness in JPM Chase card spending, retail sales, mobility, retail foot traffic, hotel occupancy, restaurant activity, consumer sentiment measures, initial jobless claims, and even certain manufacturing series such as the Empire State Manufacturing Index and the Richmond Fed Manufacturing Index.

Ironically, the negative economic data could end up being a market positive, putting pressure on Congress to get fiscal stimulus done and the Fed to increase or extend QE. In November, at least, the market was able to look past the near-term, to 2021 and 2022, when growth is estimated to be strong. Goldman Sachs estimates domestic growth at 5.3 percent for 2021, and 3.8 percent for 2022. Growth is also expected to be strong globally, Goldman is estimating global growth at 6.0 percent in 2021 and 4.6 percent in 2022. With such expected growth, low rates, trillions in stimulus, and trillions of cash on the sidelines, it is not hard to see why the markets are looking past the near-term.

Rotation was the word of the month in equity markets. Investors aggressively rotated out of growth tech into value cyclicals during the month. Many COVID winners are down more than 20 percent from their high, while we saw a sharp rally in value cyclicals, across financials, industrials, materials, energy, travel and leisure, small caps, and emerging markets. If history is any guide, we are still in the early stages of this rotation. The valuation spread between growth and value is wider than it was during the peak of the tech bubble. As Research Affiliates points out, the gap can close quickly and violently, value lagged growth by 4,000 basis points over the 14 years through 2000, before erasing that gap in a mere 13 months. With earnings expected to grow 20 percent in 2021, and the amount of liquidity in the system, it is unlikely there will be indiscriminate tech selling in favor of value. I suspect the tech selling will be more targeted. For instance, certain cloud and software names are still expensive, have poor technicals making a series of lower highs and lower lows, have tough comps in 2021, and still have extreme investor positioning. We could get to a point where many growth themes work along with value, with value leading the way to close the valuation and performance gap created over the past decade.

Outside of the equity market, it is important to keep an eye on yields, the dollar and the VIX, for continued confirmation of the rotation. The 10YR has risen from below 50bps to being on the verge of hitting 1 percent. Yields moving up and the yield curve steepening is critical for the value trade to continue to work, especially since financials make up more than a quarter of the Russell 2000 value index and nearly a third of S&P high beta. A weaker dollar is equally important for the value trade. The dollar broke long-term support at 92 on the DXY. The weaker dollar will help drive energy, commodities, industrials, and materials which make up another quarter of the Russell 2000 value index. Finally, the VIX has come in from over 40 in October. Many systematic and risk-parity strategies determine their exposure in part from volatility. As volatility comes in below 20, this will bring in a flood of capital into the equity market, allowing it to take the next leg up. Further, many systematic and quant funds were on the wrong side of the rotation, some down 20 percent or more, are likely to reallocate to value to catch-up. If yields continue to rise, the dollar weaker, and the VIX lower, capital will continue to find its way into the value trade.

Looking forward, the market will continue to focus on vaccines, the economic data, year-end positioning, and start focusing on the Georgia run-off.

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Ketu Desai is the Principal of i-squared Wealth Management Inc. ( www.isquaredwealth.com ), an investment management firm based in New Jersey. ketu@isquaredwealth.com