Summary of Market Thoughts
We believe the #1 question right now for investors is how the stock market will react as the Fed starts to taper probably in November. In 2011, 2015, 2018, and 2020, the stock market fell 10-20% over 1- 5 months during periods when monetary stimulus was flat to down. And the current daily amount of stimulus is roughly 10x what it was pre-pandemic given there was $3.2 trillion of stimulus over 11 ½ years following the GFC versus $4.3 trillion in just 1 ½ years since the pandemic. This would not matter nearly as much if 1) most valuation metrics were not at record levels, 2) inflation was also at decade highs, and 3) growth forecasts were getting cut due to the delta variant, cost pressures and supply chain issues.

Details
The year the pandemic started, the S&P500 was up 16% in 2020 on a price basis and so far it is up another 19% in 2021 despite the pandemic being ongoing. The annual historical price return for the S&P is 6% since inception so either the Pandemic is 3-4x better for the world than a normal environment or something else is driving returns.

What the past couple of years have proven is tremendous stimulus, like a powerful drug, can overwhelm the normal reaction to a cataclysmic event like a global pandemic but eventually a price will have to be paid. In this case we think the price will be persistently high levels of inflation. And the resultant necessary withdrawal of that stimulus causing the inflation will cause some powerful withdrawal symptoms. Our portfolio construction is driven from this thesis on both the long and short side.

All good things must come to an end and rising persistent inflation after 13 years of easy money policy since the GFC, marks that end. 
 
Inflation continues to be strong and at decade highs in many cases. Headline CPI of 5.3% and core CPI of 4.0% are at their highest levels in over a decade. We view inflation as more persistent rather than “transitory.” Wage increases and rental costs should continue to drive high levels of inflation despite some commodity prices retreating from their highs during the pandemic.

June home prices were up 19% y/y, surpassing the housing bubble peak, and is the highest on record since 2000. Home prices typically lead owners' equivalent rent (OER) by a year which is already up 2.6% y/y and is 30-40% of most inflation metrics and larger than food and energy combined for the consumer. 

Wage increases (average hourly earnings up 4.3% y/y) are being driven by the strong improvement in the employment picture with 10.9M job openings versus 8.4M unemployed. As a result, the unemployment rate is down to 5.2% versus a 70 year average of 5.8%.

The employment picture seems to meet the Fed’s “substantial progress” hurdle and as a result we expect the Fed to taper in November and raise rates multiple times in 2022 to deal with inflation that is more persistent than “transitory.” 

Given the market cap divided by GDP of the stock market is at 2.0x versus a peak during the Tech Bubble of 1.4x and 50 year average of 0.8x, we feel the downside risk is large. Despite 50% earnings growth from 1972 to 1974, the stock market declined by ~50% driven by persistently high inflation and slowing growth crushing market multiples (despite this also being called a “transitional period of cost-push inflation” at the time by then Fed Chairman Arthur Burns).

The longest serving Fed Chairman, William McChesney once said "the role of the Federal Reserve is to remove the punch bowl just as the party gets going." After $3.2T in stimulus over the last 11 ½ years following the Global Financial Crisis, the Fed increased the daily alcohol content by 10x and added $4.3T in stimulus over the past 1 ½ years since the pandemic. But all good things must eventually come to an end and tapering followed by rate hikes in 2022 will force investors to sober up. 

Portfolio Positioning
We are trying to maintain as many shorts as longs in the portfolio. 

Our favorite theme into year-end is sports betting as represented by the $BETZ ETF. Over 2 dozen states have legalized sports betting, but only 15 states have legalized online sports betting with more coming. In game advertising is being allowed by the NFL for the first time this season for sports betting operators. We believe this is one of the last big markets to go online. This space should grow revenues at over 30% a year for at least the next 5+ years.

We also recently bought $ATVI (one of our top 5 picks last year) given the decline of their stock driven in large part around their legal issues with the stock now down 20% YTD. We believe momentum is strong in the video game space as more people that were acquired during the pandemic are staying to play than expected. While the workplace legal issues are certainly serious, we do not expect it to affect consumer buying habits of video games. Given the lack of next generation consoles available in the holiday quarter last year due to the supply chain issues caused by Covid, we believe video game sales will hold up better than other sectors like streaming or e-commerce this holiday season. People should finally be able to get their hands on the new Xbox and PS5’s that were so hard to get during the peak of the pandemic. A bigger base of consoles will drive more video game purchases this holiday season. We think that online gaming is becoming another big entertainment source for the younger generation of consumers in addition to streaming content and social media.

Our favorite sectors in technology include legacy enterprise tech names that were hurt during the pandemic but should benefit as people go back to work such as Oracle, Cisco and recently added Dell. We added Dell post the sell-off  following their quarterly results in anticipation of the VMware spinoff. These names all trade at valuation levels well below the S&P multiple and both $ORCL and $CSCO have solid dividends with a dividend coming from $DELL post the VMW spinoff. They were all hurt by the pandemic last year as businesses cut back spending while their employees ramped up their spending and worked from home. These trends are reversing as economies slowly re-open.

We recently added to Viacom ($VIAC) at a 10x PE given strong momentum in their streaming business which is in sharp contrast to slowing at Disney ($DIS) and Netflix ($NFLX) both at ~50X PEs. Viacom’s streaming revenues were up over 90% in their June quarter to nearly $1B and momentum is expected to remain strong into next year given they are expanding internationally and ARPU should go up. For now, investors still think of them as a traditional media company, but we believe that will change and the difference in results among the relevant players during the upcoming earnings season may help that process along.

In mega-cap technology, our favorite name remains Google ($GOOGL.) They will benefit as economies re-open given 10-15% of their revenues are in the travel and leisure vertical. Revenues are expected to grow 38% this year and even grew 14% last year despite the recession. A 24x PE is inexpensive compared to the S&P at 22x for this type of growth.

We also like the financial sector (best represented by $XLF.) This sector should benefit from being able to lend at higher interest rates given our view that 10-year treasury yields should reach 2% by year end due to high inflation and Fed tapering.

We also own energy names (best represented by $XLE.) Oil prices have held in better than we would have expected despite the cuts to global growth forecasts due in part to the delta variant and supply chain issues. Oil demand should continue to improve as economies continue to reopen.

Against these positions, we are short a basket of names sitting near all-time record highs weighted towards the tech sector and names that benefitted from the pandemic.

We have reversed our Apple position from being one of our larger long positions in August to being one of our larger short positions currently.  We see upcoming iPhone 13 launch as being evolutionary with some slight changes to the notch size, battery life and camera. This follows the revolutionary 5G launch last year.  Also iPhone launch prices will likely go up relative to last year from inflation in the underlying components like semiconductors.  As a result, we believe sales in the second half of the year are likely to be disappointing as consumers retrench from pandemic driven sales last year.

Apple has been a big beneficiary from work/learn from home trends since the pandemic.  Both Mac & iPad sales were down year over year in the December quarter of 2019 before covid but were up over 70% in CQ1 of this year driven by learning from home.  iPhone sales were down in 4 of the 5 quarters prior to Covid but were up 66% in CQ1 of 2021 driven by work from home and the launch of 5G phones.

iPhone revs in FY2020 (September FY end) were 11% below FY2015 levels given incremental improvements led to lengthening replacement cycles.  As a reminder, global smartphone units were down for 4 years in a row prior to 2021. Global penetration of smartphones is high at ~50% at nearly 4B users versus an installed base of 1.5B PCs for comparison.  Meanwhile smartphone replacement cycles were lengthening prior to Covid as changes were incremental driving this decline in units.  In addition, we expect pressure on Apple’s App Store revenues given the recent EPIC lawsuit results and regulatory pressures globally on App Store commissions.
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Technically, investors have also had a tendency to “buy the rumor and sell the news” when it comes to Apple product launches.  Looking at data going back nearly 20 years, from a technical basis, Apple is typically up about 3/4ths of the time in the month leading up to their product launches but is down 3/4ths of the time the day of the event.  The stock also is roughly flat for the two weeks following the product launch before starting to climb again.

As I write this on Thursday night (7/22), the S&P is up 16% YTD and just 1% below its all-time record high on 7/12.  However, there has been a violent rotation underneath this seemingly linear move higher in the S&P.  Versus their 52-week highs, the Russell 2000 index has fallen 7% and the 10-year treasury yield has gone from 1.78% to 1.28%.  The most recent advance in the S&P, however, has been driven by the S&P technology index which was up just 1% till May 12th and since then has advanced 17% in just over 2 months.

A few factors seem to be driving these moves including: 1) a surge in the Delta variant of Covid shutting down parts of the world again, such as no spectators being allowed at the Olympics; 2) peak growth concerns as we lap the worst of the Covid-19 shutdowns a year ago; 3) seemingly more belief in inflation being “transitory” as prices for certain commodities like lumber have gone lower; 4) 10-year Treasury yields retreating from a high of 1.78% to 1.28%.

Since their highs early this year, sectors that were outperforming YTD that were geared to economies reopening and higher inflation have sold off.  From their 52-week highs, the S&P energy sector is down 13% (up 29% YTD), the materials sector is down 9% (up 12% YTD), financial sector is down 6% (up 23% YTD) and the industrial sector is down 3% (up 16% YTD).

Our view remains that economies will slowly continue to re-open as more people get vaccinated and reach herd immunity.  The Olympics banning spectators was clearly a watershed event given it was already postponed.  Having said that, roughly 3.6 billion vaccine doses have been administered worldwide.  Our view has been that as the weather gets colder, much like other coronaviruses such as the flu, Covid will also see a pickup in cases.  We also believe, much like the flu, that every year we will be getting a Covid shot given coronaviruses are known for rapid mutation.  However, close to 30M vaccine doses are being given daily.  Given the desire for humans to interact with each other, we think we will eventually develop new ways of socializing despite the presence of Covid, whether it is wearing a mask at events or getting screened before entering venues.

We also believe that inflation will be more persistent than transitory.  Headline/Core CPI are at 5.4%/4.5%. These are the highest levels since Aug-08/Nov-91. Core PCE, the Fed’s preferred inflation metric, averaged 1.6% for the prior decade. Any concerns about inflation due to the easy money policies following the Global Financial Crisis (GFC) have been wrong.  Our view is that inflation today will be more persistent versus transitory.  While clearly some increases are transitory such us comparing oil prices to negative $35 last April, other inflation components like wage and rental price increases we think will be more persistent given structural changes.  

“Although incoming inflation data are somewhat elevated, a portion of the increase… appears to have been due to transitory factors.” (6/30/04 FOMC statement). However, what followed was 17 rate hikes over 2 years which took the Fed funds rate from 1.00% to 5.25% that ultimately culminated in the Global Financial Crisis as the Fed dealt with inflation that was persistent not transitory.  

We believe wage inflation is going to be the big problem going forward and these increases are persistent and feed through to the cost of final goods and services. Average hourly earnings were up 3-3.5% in the second half of 2019 as wage pressures started to build.  Currently, the Job Openings and Labor Turnover Survey (JOLTS) is 9.2M and compares to 9.3M people that are unemployed and an unemployment rate of 5.9%. It took over 8 years for the number of people unemployed and job opening to overlap following the global financial crisis versus just over a year following Covid.  Average hourly earnings are already up 3.6%.  We believe the unemployment rate will move down rapidly as generous extra unemployment benefits expire in September with over 20 states already starting the process before then.  These wage pressures are only going to get worse as we head towards the holidays when more seasonal workers get hired.

The rise in shelter prices is notable with owners' equivalent rent (OER) up 2.3% y/y and home prices up 15% y/y. April home prices, per the Case Shiller index, is up 15% y/y which is the highest since December of 2005.  Owners' equivalent rent (OER) is up 2.3% y/y and is 30-40% of most inflation metrics and larger than food and energy combined.  OER typically lags home prices by a year so we would expect pressure on rents to continue.

And the Fed looks increasingly behind the curve as the central banks of both Russia and Brazil have raised rates three times each while England joined Canada to become one of the two G7 central bank to start tapering.  Inflation has been relatively non-existent since the GFC (and arguably for 40 years) but now is picking up globally.  Russia, Brazil and Turkey, are among the 19 central banks that have raised their main interest rates so far this year.  In total there have been 29 rate hikes this year already.  Russia’s central bank said earlier this year, "the rapid recovery of demand and elevated inflationary pressure call for an earlier return to neutral monetary policy." 

We believe the Fed will signal the start of their own tapering process by the August Jackson Hole meeting. The Fed continues to reiterate their belief that inflation is “transitory”, but their dot plot has 2 rate hikes in 2023 and they need only 2 more votes for a rate hike in 2022. In our opinion, inflation data for the next several months will force them to change their stance by the Jackson Hole meeting. 

In 2011, 2015, 2018, and 2020, the stock market fell 10-20% over 1- 5 months during periods when monetary stimulus was flat to down.  

• In 2011, the Fed hinted at not expanding its asset purchase program just before a 19% drop in the S&P 500 over 5 months. 
• In 2015, talk of balance-sheet shrinkage preceded a 12% S&P decline in just a month. 
• In late 2018, a comment about the Fed balance sheet un-wind on “autopilot” plus the ongoing trade war coincided with a nearly 20% S&P drop in 3 months. 
• In 2020, the S&P dropped 10%, with 7% in just three trading days starting on 9/2. The Fed balance sheet had been flat to down since mid-June.

GDP growth will be the best in decades both in the US and globally in 2021 driving even more demand pressure on inflation. US GDP growth following the GFC from 2010 to 2019 averaged 2.3%.  This was the slowest recovery following a recession since World War II.  As a result, companies continued to cut back on capacity expansion to match the lower-than-expected growth.  In 2020 following the pandemic, capex was cut back particularly hard as many companies tried to survive the unprecedented drop in prices.  As a reminder, oil got to negative $35 dollars per barrel at one point.  However, US GDP growth is expected to be ~7% in 2021, the fastest since 1984 at 7.2%.  World GDP growth is expected to be 6%, the highest since 1976, after falling 3.3% in 2020.  We believe, this surge in GDP growth combined with low capital expenditures will lead to a persistent, not “transitory”, increase in inflation.

The Fed may need to act in a more disruptive manner than what they have done in the past.  Historically, the Fed has acted preemptively to fend off inflation.  With their new policy of waiting to see if inflation is present before acting, there is a real risk of having to reverse policy much more quickly than in the past.  If inflation turns out to be more persistent than transitory, a rapid tightening in policy might be needed. With valuations at record highs, this might cause a much sharper stock market correction than seen during past tightening cycles, which can lead to slower growth in the future.  This might not be a near-term concern, but it is important to monitor, as this can be a portfolio changing event in the long term.

Record valuations magnify the risk to the downside given the total market cap of the US stock market divided by GDP is at a record 1.9x versus 1.4x at the peak of the tech bubble and a 50-year average of 0.8x.  This incredible multiple expansion has been driven by the repression of interest rates by the Fed buying bonds. This has driven up valuations of the entire market but especially of technology stocks.  We would note that this ratio went from 0.84x in late 1972 to a low of 0.35x in late 1974 due to rising inflation.

It is estimated that by the end of Q1, there was also over $5.4 trillion (6% of global GDP) in excess consumer savings since the coronavirus pandemic began and the US has $2.6 trillion (12% of US GDP.) Given many activities have been halted during COVID-19, the US savings rate exploded to 34% in April 2020 from 7-8% prior to COVID-19. This is more than double the previous all-time high of 15% in 1975.  Currently, this rate is sitting at 12%. When global economies reopen, this excess savings is likely to be spent and drive a surge in demand and more persistent inflation.

There are many signs of a bubble, but bubbles can continue for longer than anyone suspects.  Meme stock prices, Bitcoin prices, a non-fungible token (NFT) by Beeple (an unknown artist just a few years ago) selling for over $60M are just some signs of excess in this market.  Former Federal Reserve Chairman Alan Greenspan famously talked about “irrational exuberance” in the financial markets.  Most forget this comment was in late 1996, and the S&P peaked in March of 2000 after having more than doubled from the time of his original statement.  When the current bubble eventually bursts, it will take all stocks down, not just the more speculative stocks that are being bid well beyond normal valuation metrics.

Amazon had revenues of $1.6B in 1999 which grew to $3.1B by 2001 but the stock however went from $106 at its peak in 1999 to $6 at its lows in 2001 when the bubble broke.  Roughly 4000 other internet related companies went out of business.  Some of the most exciting technologies of today such as artificial intelligence, bio-technology blockchain, crypto currencies, digital banking, electric vehicles, green energy and virtual reality, are likely to change the world much like e-commerce did in the late 1990s.  This does not mean that investments in this space cannot get crushed if history is any guide.

Our hope is that our shorts will outperform when this bubble breaks and enable us to cushion the portfolio against a correction much like in Q1 of 2020 during the emergence of COVID-19.  In addition, our longs are primarily stocks that have growth at a reasonable price (GARP) that we believe will decline much less during a market correction. Risk management for both our long and short positions is key in this environment.

In Summary
The drivers for the US stock market record highs remain the same:

1. The Fed balance sheet hit a new record of $8.2 trillion and is up 18% y/y after being up 77% last year.
2. Money supply is up 14% y/y (peaked at a record 27% in Feb) vs a peak of 10% during the GFC and 14% in the 1970s.
3. Vaccinations & progress towards herd immunity continue.
4. The macro data is strong with the best GDP growth in decades.
5. The employment picture continues to improve with weekly jobless claims near 400K for the first time since the Pandemic.
6. Excess savings during the pandemic will be spent adding fuel to the recovery.
7. More Federal government stimulus is expected. Looking forward, the Biden administration is trying to pass another $4-5 trillion in stimulus between the Infrastructure Plan and the American Families Plan.

However, history has not been kind to the market when the Fed balance sheet has shrunk in the past and we believe a 10-20% correction in the S&P before year-end is likely.

1. The market cap of the entire US stock market divided by GDP is at 1.9x compared to the peak of the tech bubble at 1.4x and 50 year average.
2. Inflation, driven by rising rents and higher wages, is more likely to be persistent than transitory.
3. Inflation along with higher taxes is likely to eat into future corporate earnings.
4. The Fed looks increasingly behind the curve compared to other Central banks that have already started tapering or raising rates.
5. The Jackson Hole Symposium in August could mark a major shift in the Fed’s policies.
6. World changing technology stocks with the highest valuations may suffer the most during a Fed induced sell-off much like after the tech bubble burst in 2000.

Through year end, we are managing the portfolio carefully with valuations & earnings expectations near record highs.  We are favorable to sectors geared towards re-opening ($XLE -energy, $GOOGL- advertising), higher inflation (financials-$JPM) and enterprise demand picking up in technology ($ORCL $CSCO) while consumer demand cools from pandemic highs.