Contrarians Should Search Out Yield
Going against the socially accepted macro forecast is so fundamental it has its own name – contrarian investing. I prefer the French expression à rebours, against the grain. Contrarians always assume the consensus is wrong.
What isn’t widely understood is how shabbily the consensus forecast is constructed and its telling short-term impact on financial markets. Consider, after Black Monday, interest rates collapsed based on the consensus view of impending recession. The Fed changed horses in midstream, from tightening to easing credit.
But, by springtime (six months after Black Monday) it reversed course and interest rates rose from 8 1/2% to 9 1/2%. Prevailing conclusions shifted from recession around the corner and a feeble dollar to an overheating scenario of galloping inflation and a strong currency. Both points of view proved erroneous.
Security analysts understandably use trendline forecasts to extrapolate earnings for specific industries and companies. Even for major entities like Exxon Mobil XOM , General Motors GM , JPMorgan Chase JPM , Amazon AMZN and Tesla TSLA their numbers may bear little or no relationship to analysts’ projections, quarter by quarter, next year.
When you begin to hear stray voices mumbling there’s a 10% chance of a recession, assume it’s 50%. When you see 50% in print, probably you’re in the eye of the maelstrom and it’s time to plan a bigger commitment to equities. Absent lead time, you’re nowhere.
Today, the consensus has congealed around the point of view of recovery that basic industrial earnings power reasserts itself in 2021. The blood stops flowing from airlines and banks see rising loan demand and leveraged net-interest margins. This point of view emerged at yearend 2019, but by mid-2020 was totally discredited. Citigroup C got cut in half while JPMorgan flopped from $140 a share to $90. Polite energy plays like Exxon Mobil got halved as well. Its dividend yield 10%, currently, forecasts it will be halved by mid-2021. About time!
The S&P 500 Index sells above 20 times consensus earnings forecasted for 2021. To start with, this is a dangerous multiplier, historically speaking. More pressing is the issue of when pharma research successfully achieves an airtight Covid-19 vaccine. The market assumes this happens by yearend, but no hard facts as yet exist except phase-three testing by several drug houses actively is in the works.
Meanwhile, the high-yield debt market remains a partial proxy for stocks, never contrapuntal. On a big-down day, like past Wednesday, high-yield bonds dropped around 1%. This action reflected residual fears that if the recession elongated into 2021, interest coverage for this bond paper would diminish.
I think I’ve solved such residual fears by not operating below BB credits and limiting bond duration to five years. Fixed income investors have few viable alternatives. Ten-year Treasuries yield 60 basis points, 30-year paper under 1.5% with AAA corporates not offering much more.
My thirst for high-yielding paper ranges to include MLPs, but so far, I’m wrong. MLPs are captive to weak oil futures and issues of pipeline throughput and pricing in a period of lower oil consumption and depressed gas pricing. I’ve confined myself to higher-quality paper like Enterprise Products Partners EPD , Williams and Magellan Midstream Partners. So far, I’m wrong even though I count on them covering shareholder distributions on my cash flow estimates.
What about ragamuffins trading in single digits? The list embraces washed out properties like U.S. Steel, General Electric GE , Energy Transfer and Plains Group Holdings. Then, there’s Macy’s M , Teva Pharmaceutical Industries and Ford Motor F . Airlines like American Airlines Group AAL got cut into thirds with Alcoa AA schmeissed in half. Plenty to whet your appetite but I’m holding back because much of this paper is cyclically vulnerable and carries serious risk of bankruptcy.
Ironically, growth stocks like Amazon, Facebook, Alibaba BABA and Microsoft MSFT despite rich valuations, hang in. Acting better than the market because there’s no cyclical variance in earnings as yet. This is a big call. Do you have the courage to overweight them? So far, I’m all-in.
Now is the time to weigh whether Alibaba, Facebook and Microsoft sail through choppy waters relatively unscathed. I believe in them, but all of us should be considering our basic investment construct. This will determine how we come out. Nobody should be more than 60% invested in equities with 40% allocated to fixed income properties with attractive yields.
Investment-grade bonds are a no-no because of their minimal yields. High-yield bonds get 30% of my assets and so far, so good. I expect my investment return this year to reach 10%, half income, half price appreciation.
I’ve avoided stock sectors like financials and energy with exceptions in high-yield MLPs. Let JPMorgan sink down close to book value, $80, and I’ll nibble away at it. Citigroup already is deeply discounted, selling over 40% below book value. Its dividend yield is still a skimpy 4.8%. I want more.
Over sixty years, averaging my costs on borrowed capital, I come out somewhere between 6% and 7%. FRB chairman McChesney Martin was my nemesis in the sixties. When inflation reared its head, he’d take away the punchbowl, spiking margin requirements to 90% while money-market rates shot up unmercifully. I turned to money brokers to fuel my obsession with convertible bonds like Boeing BA , United Aircraft and Eastern Air Lines which all doubled and tripled as the jet age unfolded in the world.
If domestic interest rates snake along ground zero, the price-earnings multiplier for growth stocks holds in high ground. Curiously, the recent changes in the Dow Jones Industrials list put the emphasis on growth. The Dow Jones should drop “Industrials” from its name. It is no longer descriptive of this index which more and more looks like the S&P 500 Index.
Wisely, to remain competitive as an index, the Dow can’t count any longer on stocks like Exxon Mobil, halved by the market past five years. I regard pre-technology market leaders before 1960 as the uninvestables. Stocks like U.S. Steel, Alcoa, General Electric, even General Motors and Ford Motor sport overleveraged balance sheets and stagnant demand for their output.
Never forget, rising bond yields top out any bull market within a year or two. The reciprocal is true, too. During the nineties, the 10-year yield on Treasuries started at 7.8%, then declined to 6% until 2000. The S&P 500 Index started out at 15 times earnings, but ended the decade near 30 times. Tracking the rate for Federal Funds, I was surprised to see it as low as 25 basis points in 2015 vs. its long-term trend at 4%. Nobody sees 4% coming back. Even a rise to 2% shouldn’t panic the bond market. With 30-year Treasuries at 1.5%, even a rise to 3% shouldn’t impact price-earnings ratios, considering a 4.5% yield is the long-term norm.
Turbulence was 2020’s middle name. Nasdaq 100 Index rose 11% in August, ahead 38.7% year-to-date. Few high-energy operators did better, almost all underperformed.
Sosnoff and/or his managed accounts own Amazon, Citigroup bonds, Enterprise Products Partners, Williams, Magellan Midstream Partners, Energy Transfer, Ford Motor bonds, American Airlines Group bonds, Facebook, Alibaba and Microsoft.