• Political Uncertainty Continues
  • Caution! Historically high valuations and exuberant sentiment
  • Rising interest rates drive growth to value rotation
  • Rising Covid-19 lockdowns could trigger a Q1 correction
  • Antero Resources (AR) and Antero Midstream (AM) are compelling natural gas stocks
The great vaccine results, led by Pfizer, AstraZeneca Oxford, and Moderna, have transformed global economic prospects and pushed the S&P 500 to new highs. While wide-ranging global vaccinations will take over a year to fully implement, locked-down industries should begin returning to normal. The post COVID return to normalcy will boost growth, reduce unemployment, and improve earnings, but several critical risks can reverse this hopeful outlook and twelve year old bull market.

Unchecked Taxation:

The Georgia Senate race on January 5th could have a major impact on the market. If Republicans Kelly Loeffler and David Perdue fail to win those seats, control of the Senate could shift to the Democrats. Since Joe Biden has stated he would reverse the Trump tax cuts, potentially $4 billion in new taxes funded through higher corporate tax rates would become law if the Democrats win the senate under a Biden Administration. A rise in corporate taxes from 21% to 28% will cut S&P earnings, curtail employment, and reverse the Trump tax cut market gains.

Historically High Asset Prices:

The chart below by Nobel Laureate Robert Shiller shows stock valuations and interest rates since 1880. Interest rates have experienced a dramatic 40-year decline, from 15.32% in 1981 to 0.62% in July.

A rise in interest rates, by definition, will hurt bond portfolios. Further, stock market valuations are affected by the return profile of alternative assets. Bonds are the largest and most liquid investment alternative to stocks. Rising rates can lead to a dramatic revaluation in the stock market as experienced in 1987, when the stock market declined 22% on October 19th. During 1987, 10-year US Treasury yields rose from 7.08% to 9.52%, which in combination with Wall Street’s ingenious portfolio insurance, created an epoch market crash.

Since 1981, Wall Street has enjoyed a 40 year epoch financial boom driven by declining interest rates and the 60% equity and 40% asset allocation methodology. The symbiotic feedback loop of portfolio rebalancing between stocks and bonds could soon reverse with rising rates, inflation, and record high equity valuations. The combination of rising rates and inflation could create a grim market and economic environment reminiscent of the 1970s when commodities and hard assets were leading asset classes.

Euphoric Sentiment:

Current interest in IPOs is a classic sign of investor speculative extremes. The chart below shows that current behavior parallels the activity seen in the 2000 bubble.
The CBOE Volatility index suggests that the number of buyers of protective options has dropped significantly since the March market crash. The combination of high valuations and record speculation are strong indicators of a market vulnerable to a pullback or crash. These indicators are market sentiment measures, not timing instruments, suggesting the downside could occur in the near term or even a year later.

Rising Interest Rates:

The economic recovery will lift interest rates and reverse the Federal Reserve’s unprecedented accommodation which began following the 2008 financial crisis. Today’s historically low interest rates have elevated financial asset prices to record levels. The Federal Reserve’s August policy shift to tolerate inflation over 2% reversed 40 years of central bank inflation fighting. As the economy recovers, the Federal Reserve will allow inflation to run hotter and this behavior should lead to higher long-term interest rates.

The interest rate display below shows that in 2018 and 2019, 10-year US Treasury yields ranged between 3% and 1.63%. Rates are rising from their July low of 0.62%. Interest rates should return to the 1.6% to 3.0% range. With a global economic rebound and a rise in inflation, rates could rise even further. Rising interest rates will negatively impact bondholders and raise financing costs.

The chart below of the 10-year US Treasury yield shows bond yields rising since July. Interest rates will move higher as COVID-19 lockdowns abate and vaccine distribution assures economic normalcy.

Earnings will Rise with Economic Recovery:

The rising earnings trend in S&P – shown by the red line in the middle panel in the chart below – is a powerful driver of investment flows. The S&P 500 did not roll over until July 2000 and July 2007, when that earnings line turned down. A deceleration in earnings combined with rising rates should mark the end to this bull market.

COVID-19 and Lockdowns:

Increased testing for COVID-19 and heightened seasonal proximity have accelerated this pandemic’s current wave. Many states have taken draconian action against the hospitality, travel industry, and other venues where the spread of the virus is believed to be greatest. These actions, in the name of good health policy, have had a decidedly negative impact on economic growth. We anticipate this virus’ spread and rise in death rates will peak in the coming months and reverse with the rapid deployment of the vaccines. Passage of an economic relief package could ameliorate this economic headwind, but political brinkmanship has restrained rational policy.

Monetary Stimulus and Inflation:

The Federal Reserve has added massive liquidity to halt the COVID-19 economic collapse. This historic stimulus has added massively to the money supply shown below. This parabolic increase in money supply combined with the Modern Monetary Theory, which espouses no consequence to unlimited government debt issuance, risks rising inflation. Extreme cases of monetary irresponsibility have devastated Venezuela, Zimbabwe, Argentina, and Germany in the 1920s.

The Inflation Cycle:

We appear to be at an inflationary tipping point. This critical turn is displayed below in a chart of the S&P 500 to the Goldman Sachs Commodity Index. Commodities should be overweighed and stocks underweighted when the chart is moving higher. When the ratio is declining stocks should be overweighted and commodities underweighted. Now, the ratio is turning up.

The Growth to Value Rotation:

Since September 2nd, when we observed a gap opening in the NASDAQ 100, we have been selling large-cap tech and buying value. The chart below shows that Wilshire Growth/Value recently reversed its recent parabolic run. In the interim, commodity stocks have outperformed and FAANG stocks have lost their momentum. This trend should continue as reopening stocks outperform and large-cap tech stocks’ earnings momentum deteriorates. This spring, tech stocks’ earnings will compare against last year’s extraordinary lockdown-enhanced earnings. These difficult earnings comps and growing anti-trust actions should weigh heavily on large-cap technology.

Natural Gas Stocks:

We continue to buy and recommend Antero Resources Corporation and Antero Midstream Corporation. These two large natural gas companies, located in the Utica and Marcellus shales, are pure-play natural gas producers and processors. Our fundamental thesis remains that the 11-year bear market in natural gas has ended. With the collapse in drilling from the 2020 oil crash, associated natural gas supply has been curtailed, while demand for clean-burning natural gas enjoys growing global demand.
The management of both companies is significant shareholders, who are astute managers and former Lehman investment bankers. Since the fourth quarter of 2019, Antero Resources bought $37 million of their stock and bought back $1.6 billion of their debt at a discount and reduced $220 million in debt face value. This restructuring was accomplished during the first half oil crash using asset sales and cashflow. The company is poised for significant cashflow growth enhanced by improving natural gas and NGL prices. We estimate that Antero Resources could trade to $20 per share within two years.  Antero Midstream has maintained its high dividend with its operating cash flow. AM’s dividend yield is 14.5% and should see its yield normalize toward 8% as the energy market and global economy stabilize.

Conclusion:

Markets have priced in both a benign divided government with a Biden Presidency and a Republican Senate and the successful deployment of several highly effective vaccines. These expectations will provide an economic pathway to normalcy. Positive earnings momentum, supported by a rotation toward value, cyclical, and commodity stocks, should support stocks well into the new year; however, rising rates, weakening tech leadership, COVID-19 lockdown momentum, and political uncertainty make this expensive stock market precarious. Rotating portfolios into value and cyclical stocks and out of technology stocks could lead to years of outperformance. Selling bonds and adding to commodities is a prudent strategy to offset the downside of rising rates and emerging inflation. We recommend selling into market euphoria when market volatility is low, and buying out-of-favor sectors when the market is panicked as we did last spring buying energy–MLPs and natural gas stocks—that now are considerably higher.

2020 was a year of unexpected extremes. We are planning for 2021 to be another surprising year. We welcome your questions and comments.

Happy Holidays!