As the havoc of the latest COVID variant sets in, stock markets brace for yet another reopening trade (YARO).
Yes, there we are with the expert definition and nuances of the word âtransientâ and the debate that follows with respect to inflation. We have argued that the North Star in this current equity regime is an expansion of the earnings cycle. The challenge of this period has become the start-stop-and-start-again reopening movement as the complexities of COVID / supply chain events distort a traditional profit rebound.
We continue to advocate for investing in better quality companies to better navigate this period while limiting exposure to innovative companies to reduce risk. Secular highs in innovation stock valuations are a source of risk as interest rates reverse and Fed observation returns to prime time.
Investors will once again turn their gaze to a tantrum. In this back-and-forth state of COVID-on, COVID-off, chasing after gang tails will leave investors tired as they frantically recalibrate their portfolios. The focus on top quality with a valuation bias should offer the best way forward as investors weigh the chances of another trade reopening.
This back-and-forth movement between lower-than-expected inflation and fears of liquidity-induced reflation has drained investors this cycle as we head into a likely choppy fourth quarter. As the global economy has started to reopen, albeit in a mixed fashion, sales growth in the United States has rebounded to 7.4% year-over-year with the latest reports.
In other words, the early stage gains are probably behind us. Investors must position themselves for continued expansion and look to companies with higher profit margins and better balance sheets.
Importantly, high-quality companies remain particularly discounted as investors ignored basics like margins and balance sheets to chase after innovation-driven, cash-focused names during the lockdown. This was further exacerbated as the vaccine / reopening wave inflated deep cyclics.
Combined, these elements explain why top quality companies sell at historic discounts. Compared to low-grade firms, high-grade firms trade at EV / sales that are 1.4, 1.8, and 1.1 standard deviations, respectively, below their historical averages for large, medium firms. and small cap.
The fallout from the reopening should also continue to exert upward pressure on rates, negatively affecting aggressive growth and innovation stocks.
COVID infection rates have started to decline, again signaling a shift in markets from a narrow economy to a reopening posture. Unsurprisingly, the Fed’s observation has resurfaced as stocks with rich multiples need a low / favorable interest rate environment to thrive. A complete reopening of the global economy puts aggressively growing companies trading at historic highs at risk.
We saw a rate risk for the innovation baskets when they fell when rates rose in September. Historical data points to another example of the sensitivity of equity market performance to fluctuations in interest rates. In a short period of time from the end of July to the end of September, yield on the 10-year Treasury bill TMUBMUSD10Y,
climbed to 1.46% from 1.18%. The fallout from the stock market has been quite direct – the Nasdaq Composite COMP,
lost 1.53%, the growth index fell 1.10% and the tech sector lost 1.23%. Note that as fears of the delta variant appear to be easing and vaccination rates have started to rise, investor attention has returned to the reopening and therefore central bank policy.
As US businesses and schools reopen, the focus on liquidity will continue to fuel the fears of nervous market players struggling to weigh on the sustainability of the Fed’s liquidity support. That nervousness temporarily subsided as the COVID variants attacked important regions within states. While the surge in innovative equities started with a historic increase in liquidity, investors are rightly concerned that any attempt to reduce market support will have negative spillover effects on the valuation of the more aggressive parts of the equities landscape. .
The innovation sector may be the epicenter of market attention as interest rates turn turbulent. Figure 2 below shows the high valuation of innovative companies represented by the next-generation Internet ETF ARK ARKW,
At the end of August, the ARK Next Gen Internet ETF traded at 13.4x EV / sales against 3.6x EV / sales for the large and mid-cap markets.
More broadly, the tech sector is also trading at extremely wealthy levels. On a historical basis, the small business tech sector trades at an 85% premium to the overall market, compared to a long-term premium of 33% on an EV / rolling sales basis. The large and mid-cap technology sector trades at a premium of 113% over the overall market compared to the historical premium of 58%.
Although a far cry from the multiple highs seen in February, smaller innovation stocks are trading at more than 20 times sales and large caps north of 19 times sales. During the September sell-off, we saw large-cap innovation stocks weaken by more than 5%.
Conclusion: As the US economy continues to reopen, it becomes increasingly clear that companies with the highest expectations cannot climb much higher or maintain existing premiums from current levels.
The North Star in the current environment remains an expanding earnings cycle that will continue to force attention to valuations. Innovation firms are likely to struggle as the reopening takes hold and negatively impact U.S. interest rates. Above all, turning to companies with higher margins and better balance sheets will become more important as this recovering profit cycle ages.
Satya D. Pradhuman is CEO and Research Director at Cirrus Research.
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