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Good morning. At 8:30am today, not long after this newsletter arrives, the December CPI data release will hit. At that point there is likely to be, in the words of Bill Murray in Ghostbusters, “Human sacrifice! Dogs and cats living together! Mass hysteria!”
Inflation is the single most important variable for the market outlook right now, so the excitement is warranted. But we hope you have a few calm moments to read the about stock valuations and market-making before the biblical scenes kick off.
One word of clarification about yesterday’s comments on inflation, which generated a fair amount of interest. As we wrote, we are not too worried about shelter inflation (likely to come in hot today) and we are not convinced that the Fed remains badly behind the curve.
But Ethan and I are not on Team Transitory. We are hopeless fence-sitters on inflation, and we will be taking no victory laps however things turn out. If we often take up the transitory side of the argument, that is only because it has been widely declared dead, and we don’t understand why.
The arguments that inflation should fade quickly in the latter half of this year and heads into next year under 3 per cent are quite reasonable, if not decisive (here is a representative one). If that happens, history will look back and say, “yep, transitory”.
Anyway, email us: firstname.lastname@example.org and email@example.com
Are bargains appearing in the stock market?
We’ve written quite a bit about market breadth, or the lack of it, recently. Our conclusions have been that yes, the market is getting thinner — it is being supported by the performance of fewer and fewer stocks — but no, we are not altogether sure that this is the ill omen it is generally considered to be.
Looking at breadth in the abstract (ie, “X per cent of stocks in index Y are Z per cent off their highs,” or similar) might be less useful than looking at it in concrete terms, however. In a given index, which companies are getting whacked and by how much? Is there a pattern?
Looking at this might tell us whether declining breadth was really something to worry about. And as a bonus, it might reveal the thin market is creating pockets of value. After a period of pervasively nutty valuations, are bargains emerging?
The Nasdaq 100 is a good index to start with because it is a manageable size, is made up of well-known stocks, and is mostly tech, which has gotten whacked. It has been going sideways since September.
Using an S&P CapitalIQ screening tool, I had a look at how the 100 stocks in the index have done. Twelve of them have lost a fifth or more of their value in the past 12 months. This is a change: a year ago, none of the stocks in the index were nursing such big declines. The list of the badly bruised includes wild growth plays such as Zoom and Peloton, but also sturdier tech companies such as PayPal, and the mobile carrier T-Mobile.
A third of the index is flat or down from a year ago, spread across sectors (tech, retail, pharma) and from growth (Lululemon) to value (Amgen). Valuations are starting to come in, too. The index still looks expensive (the index average price/earnings is over 40), but fully 60 of the stocks have had their forward price/earnings ratios decline over the past year, twice as many as had declines in the year before.
The top third of the index looks very strong, or course. All boast annual gains of 25 per cent or more. But this index is wagging a big, diverse tail of stocks with weak performance. It does not tell a tale of pervasive investor confidence, as indices with strong breadth do.
Look at the bright side, though. Cheaper stocks mean higher long-term returns. And it looks to me, on first pass, that bargains might be emerging. I looked at stocks that were down at least 20 per cent from their 52-week highs, and then screened for valuations, growth rates, and gross margin/assets ratios (a rough proxy for business quality and pricing power, which are going to be important if inflation persists). A grab-bag of stocks turned up that, purely on the numbers, look intriguing. Here are some of the names the screen churned out:
The five columns, running left to right, give a sense of how beat up the stock is; its valuation: the quality/pricing power of the business; its growth; and how much you are paying for that growth (the ratio of P/E to revenue growth or “PEG” ratio).
These numbers — like the output of any screen — will have to be scrubbed and double checked for anomalies and so forth. And goodness knows this ain’t investment advice. The point is just that the market is throwing up some beat-up names that look intriguing. There are not yet many outright cheap stocks to be found (the second column contains some mighty high P/Es). But those high valuations are matched by high growth rates (see the final column: any PEG ratio under 1 is attractive). And these are quality businesses (see middle column, where gross profit/assets over 30 per cent should grab your attention).
More work to be done, for sure. The point is that a flip side of a thin market is opportunities for bargain hunters. If markets remain choppy, this could be a fun year for value investors.
Ken Griffin’s sensible hedge
Ken Griffin, you might’ve heard, has just received a pretty nice sum for a minority stake in his Citadel Securities, a dominant market marker in stocks, credit and derivatives. Venture investor Sequoia Capital and crypto specialist Paradigm now own $1.2bn of the market-making firm, valuing it at $22bn. There is buzz about Citadel adding a crypto trading operation.
What sort of business are Sequoia and Paradigm getting for their money? Citadel Securities doesn’t disclose financials, so we had a look at a rival that does: Virtu Financial, the other big kahuna in market making.
Two things matter in the market-making business: trading volume and market volatility. In early 2018, Virtu shares spiked as volatility slammed markets. During the pandemic, a flood of retail trading activity has helped push the stock up 80 per cent:
Citadel Securities is not exactly like Virtu. It is bigger and trades in different markets. But it is clear that Sequoia and Paradigm are betting that the increases in retail trading volume and volatility will persist when the pandemic finally passes.
Complicating matters further, BestEx Research’s Hitesh Mittal points out that volume and volatility are coming apart more often these days. How good is, say, a high-volume but low-volatility environment for Citadel Securities? We can only speculate.
In any case, it is a good time for Citadel Securities — and Griffin — to diversify. Adding crypto to the market-making mix creates a new revenue stream. And taking some profits at what might be the top isn’t such a bad idea, either. (Ethan Wu)
One good read
A problem that does not get enough attention: developed-economy monetary policy widens inequality among nations.
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