Dear Hedgeye Nation,
We just hosted 10 of the sharpest investing minds on HedgeyeTV for a 3-day bonanza of world-class interviews. To kick off our semiannual Hedgeye Investing Summit, Hedgeye CEO Keith McCullough was joined by the Chief Investment Strategist at Charles Schwab, Liz Ann Sonders.
Below we have transcribed key excerpts from their conversation.
You can access the entire hour-long interview, as well as the 8 other financial market webcasts, here.
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McCullough: Today’s an interesting day; it was the day that the Dow was down -12.9%, the second worst day in its history. One of the things I like most about your work is it’s filled with numbers. I read a lot of narratives, and you have to stop reading because there are no numbers.
There’s a lot of focus on the way the world should, could or would be – but you’ve put this in context of the cycle. It would be great you could take a step back and go through the past year, which isn’t a long time in cycle time, and take a crack at where we are today.
Sonders: It’s amazing, the condensed period of a time that we’ve essentially gone through a full cycle. The condensed nature of the bear market was driven by several factors.
The obvious one that we all talk about is that double-barreled coming out of the Fed and Congress, which is certainly what differentiated Covid-Crisis from the Financial Crisis.
What a lot of people don’t remember is that the timing of the bottom, March 23rd, 2020, wasn’t so much about what the Fed had done up until that point, but they announced some of the backstop facilities even before they were setup, which shows the power of their words.
A less discussed force that I think caused the market to bottom when it did, was that was the last week in the Quarter, so a lot of [mutual] funds do their re-balancing the last week of every quarter.
Using simple math – if you were say a 60/40 fund, you re-balanced to that at the end of 2019. Fast forward to March 23rd, you were maybe 48/52. So I think there was a re-balancing trigger that also went quickly into the equity side of the equation.
We’ve also had several phases to the equity rebound. The first two broken up by a little bit of a corrective phase in June, were what I’ve been calling “concentrated recoveries,” so the dominance of the Big 5 at the expense of pretty much everything else. And that persisted until September. Then we had a little bit of a rotational corrective phase in both September and October.
Then by October and early November, certainly in conjunction with the Pfizer news, we got that broadening out down into the more cyclical parts of the markets and economy – the areas that hadn’t performed. The speculative froth started to concern me back in August. Back then though, it was more concentrated, in the Big 5 or the options market. Starting this year however, sentiment became pretty frothy across just about every behavioral and attitudinal measure.
Then the flash mobs started to move into more speculative, less quality-driven, sections of the market; be it heavily-shorted stocks, or non-profitable tech companies.
We’re in the process of seeing more of this rotational corrective phase, which will maybe ease some of the excess without the entire market coming down with it. That would obviously be the most benign scenario going forward to ease some of the speculative forth, versus say an early 2000 situation where the bottom just falls out of everything.
McCullough: It is a compressed period of time. In my speak what you just said was what ended in September was Quad 3. People crowded into these mega-cap, low short-interest, widely owned named. They crowded into Gold, Treasuries, and plenty of big asset allocation mistakes.
To me it’s just clean cut that since November it’s been Quad 2, with growth and inflation accelerating at the same time.
In my world, I wonder how you unpack a couple of these things. 1) Everyone crowded into Momentum – Tesla (TSLA), Apple (AAPL), and Microsoft (MSFT) are the three big constituents of the momentum basket, and that started to blow up.
What is it about Momentum as a factor exposure coming undone, versus the cycle itself?
Sonders: I think of Momentum a bit differently than maybe other people think of it in a standard way.
I consider Momentum to be wherever the most price appreciation has been. You could have Momentum in classically “defensive” areas – you can have it in Utilities stocks or Treasury bonds. What was unique about when we had the Momentum was in the Big 5, the FAANG-type stocks, those companies represented the COVID version of defensive areas. When we think of defensive we usually think of Consumer Staples and Utilities.
Yet during the unique time that was COVID, you found defense in what you’d typically think of as “Growth” stocks or high-Momentum stocks.
In a world when the entire economy is shut down, and all we’re doing is living in the ecosystems of these companies, they became inherently defensive. So these rotations have also been a shift in where Momentum goes – and more recently it’s gone into these more arcane parts of the market, but it very well could come back.
We could see a flip flop within a day or two, an exact mirror image.
McCullough: Momentum can be Value, it can be Growth, it can be anything that’s going up. A lot of people have been sucked into a narrative on Growth vs. Value. I’m long a ton of value in the Industrials, Energy, Financials, and Basic Materials sectors. These are not expensive speculative froth. Even if it was a bubble, I wouldn’t care. In fact I would appreciate being long a bubble as it’s going up, because you make a lot of money.
I do think that differentiation that you made is important; the Old Wall is stuck with the naming of certain things.
Sonders: The Growth vs. Value point, I couldn’t agree with you more. It’s important to differentiate between Growth and Value as in the indexes (i.e. Russell Growth, Russell Value, either large or small) and the factors or characteristics of growth and value.
I think this will be a value (lowercase “v”) driven market – investors will be best served by having a bit of a value-mindset. But that doesn’t mean you should put blinders on, look at a value index, and think you need to be wherever the 'dominant factors' are.
Think about October of 2002. The tech bust had finally ended, the S&P 500 was down -57%, the Nasdaq 100 down more than -80%; if you were a value-oriented investor, you would’ve made a killing by going deep-value, but in terms of buying some of the most under-valued growth/tech stocks. Russell didn’t move them into the value indexes, but that’s where you find value. If you just put blinders on and bought the value index, you would’ve bought the stuff that’s always in value, like Utilities and Telecom at the time.
You wanted to be a value investor then, but the money you made was investing in lower-value growth companies. The most recent example I give is that Utilities are expensive right now and don’t offer a lot of value; Russell didn’t move them into the growth indexes, they’re still value, but they just don’t offer a lot of value.
Especially in an environment like this, you can focus on value, but don’t box yourself in.
The other issue here is that it’s a bit of chicken and egg. We’ve had forces that have been driving Financials and Energy since they’re relative lows back in late October; that has been to the benefit of value indexes. The Russell 2000 value index has 28% of Financials – you get a big move in Financials, you’re going to get a big move in small-cap value. Sometimes the headline is “Investors plough into small-cap value” well sometimes it’s been a huge few days/week/month or whatever it is, which boosts the index.