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Good morning. At 08:30 today, not long after this newsletter arrives, the December CPI data release will hit. At that point, there was probably, in the words of Bill Murray in Ghostbreakers“Human sacrifice! Dogs and cats living together! Mass hysteria! ”
Inflation is currently the single most important variable for the market outlook, so the excitement is justified. But we hope you have some quiet moments to read about stock valuations and market creation before the biblical scenes kick off.
One word of explanation about yesterday’s comments on inflation, which generated a fair amount of interest. As we wrote, we are not too worried about shelter inflation (will probably be hot today) and we are not convinced that the Fed is staying badly behind the curve.
But Ethan and I are not on Team Transitory. We are hopeless hedgers about inflation, and we will not take any victory rounds no matter how things turn out. If we often take up the passing side of the argument, it’s just because it’s widely declared dead, and we do not understand why.
The arguments that inflation should fade rapidly in the last half of this year and enter below 3 per cent next year are quite reasonable, if not decisive (here is a representative one). If that happens, history will look back and say, “yep, passing”.
Are bargains appearing in the stock market?
We recently wrote a lot about market breadth, or the lack thereof. Our conclusion was that yes, the market is getting thinner – this is supported by the performance of fewer and fewer stocks – but no, we are not entirely sure that this is the bad sign that it is widely regarded as.
Looking at the breadth in the abstract (i.e., “X percent of stocks in index Y are Z percent of their highs,” or similar) may be less useful than looking at them in concrete terms. In a given index, which companies are defeated and by how many? Is there a pattern?
If we look at this, it can tell us whether the declining width was really something to worry about. And as a bonus, it can reveal that the lean market is creating pockets of value. After a period of pervasive muddy valuations, bargains are coming up?
The Nasdaq 100 is a good index to start with, as it is a manageable size, consists of well-known stocks, and is mostly technology, which has been squeezed. It’s been going sideways since September.
Using an S&P CapitalIQ selection tool, I looked at how the 100 stocks in the index performed. Twelve of them have lost a fifth or more of their value over the past 12 months. This is a change: a year ago, none of the stocks in the index caused such large declines. The list of the badly bruised includes wild-growth plays like Zoom and Peloton, but also firmer technology companies like PayPal, and the mobile service provider T-Mobile.
A third of the index is flat or lower than a year ago, spread across sectors (technology, retail, pharma) and from growth (Lululemon) to value (Amgen). Valuations are also starting to come in. The index still looks expensive (the average price / earnings index is more than 40), but in full 60 of the shares’ forward price / earnings ratios have fallen in the past year, twice as much as in the previous year.
The top third of the index looks very strong, or natural. All boast annual profits of 25 percent or more. But this index is swinging a large, diverse tail of stocks with poor performance. It does not tell a story of penetrating investor confidence, as strong-width indices do.
However, look at the shiny side. Cheaper stocks mean higher long-term returns. And it seems to me, with the first time, that bargains may be popping up. I looked at stocks that were at least 20 percent lower from their 52-week highs, and then checked for valuations, growth rates and gross margin / asset ratios (a rough proxy for business quality and price power, which is going to be important if inflation continues) . A grab bag with shares showed up which, purely on the figures, looks interesting. Here are some of the names that took the screen out:
The five columns, running from left to right, give a sense of how beaten the stock is; its valuation: the quality / price power of the business; she grows; and how much you pay for that growth (the ratio of P / E to revenue growth or “PEG” ratio).
These numbers – like the output of any screen – will need to be scrubbed and double checked for deviations and so on. And the good ones know this is not investment advice. The point is just that the market is throwing up some knock-up names that look interesting. There are still not many cheap stocks to be found (the second column contains some mighty high P / Es). But those high valuations are offset by high growth rates (see last column: any PEG ratio below 1 is attractive). And these are quality businesses (see middle column, where gross profit / assets should attract more than 30 percent of your attention).
More work to do, for sure. The point is that a flip side of a thin market is opportunities for bargain hunters. If markets remain volatile, it could be a fun year for value investors.
Ken Griffin’s Sensible Fence
Ken Griffin, you may have just heard of a receipt quite nice sum for a minority stake in its Citadel Securities, a dominant market maker in equities, credit and derivatives. Venture capitalist Sequoia Capital and crypto specialist Paradigm now own $ 1.2 billion from the market-making firm, which values it at $ 22 billion. There is gons about Citadel adding a crypto-trading operation.
What kind of business does Sequoia and Paradigm get for their money? Citadel Securities does not disclose financial information, so we looked at a competitor that does: Virtu Financial, the other big kahuna in market making.
Two things matter in the market making business: trading volume and market volatility. Early in 2018 part Virtu increased as volatility hit markets. During the pandemic, a flood of retail activity helped boost stocks by 80 percent:
Citadel Securities is not exactly like Virtu. It is larger 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 continue when the pandemic finally passes.
To further complicate matters, BestEx Research’s Hitesh Mittal points out that volume and volatility are falling apart more frequently these days. For example, how good is a high-volume but low-volatility environment for Citadel Securities? We can only speculate.
This is a good time for Citadel Securities – and Griffin – to diversify anyway. Adding crypto to the market making mix creates a new revenue stream. And taking a little profit on what might be the top is also not such a bad idea. (Ethan Wu)
A good read
A problem that does not receive enough attention: monetary policy of developed economies inequality increases between nations.