Finding Value in a World of False Signals – June 5, 2020

Finding Value in a World of False Signals – June 5, 2020
Morgan Lewis Posted on June 5, 2020

Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

Finding Value in a World of False Signals

The market continues its seemingly inexorable march higher. In light of the lasting and in many cases existential damage that COVID has wrought on the earnings power of so many companies, it is a huge challenge for us to put this rally into context in light of civil unrest, a global pandemic, and 40 million unemployed Americans. All of the major averages had a very big week. The S&P was up 5.1 percent, the Dow Jones Industrial Average was up 7 percent, the Russell 2000 was up 9.2 percent, and the NASDAQ Composite was up 3.6 percent.

You know the environment has turned frothy when the leader of the free world is calling out the world’s most famous value investor on having sold airline stocks, and when many stocks of notable companies that have filed bankruptcy over the last 60 days are trading above their prices just prior to the filing. Robinhood day traders seem to rule the day, and the poorer the fundamentals, the more extreme the move in the stock. This is indeed apparent in the ML Most Shorted Most Levered Index, up a whopping 19.7 percent for the week. It is somewhat reminiscent of the late 1990s, where perception was that making money in stocks is easy.

As you might imagine, the more cyclical end of the hard assets universe performed exceedingly well in this kind of market backdrop. They tend to have been the most heavily shorted names, and it is clear that there is a scramble to cover. The GNR S&P Global Natural Resources index was up 9.4 percent for the week, largely led by energy. The optimism around the OPEC + meeting slated for this weekend was the tinder for an incredible move in oil prices and related stocks. The S&P Oil and Gas Exploration and Production Index was up 22.5 percent, and the OIH Oil Services Index was up 28.8 percent. While these stocks largely remain well below prices we saw pre-COVID crash, the rally has been impressive. We are concerned that the oil market has gotten very far ahead of itself, particularly in that the OPEC cuts are temporary and there are some E&P companies already reacting to higher prices by drilling their “DUCs” (drilled uncompleted wells). US supply has dropped from a peak of about 13 million bpd to its current 11.5 million bpd. We need producer discipline to persist in order for excess inventories to draw and the market to become more balanced in order to have sustainably higher prices. Industrial commodities also fared well, with the S&P Metals and Mining Index up 10.2 percent and the MSCI Global Metals and Mining Index up 10.4 percent.

The more “stable value” areas of hard assets fared well also. However, we are quick to point out that, increasingly, balance sheets matter for business model sustainability, and much of what we have come to think of as stable value requires differentiation. The Dow Jones Equity REIT Total Return Index was up 9 percent for the week. However, performance was exceedingly bifurcated. The Bloomberg REIT Regional Mall Index was up 48.2 percent for the week, and clearly there was a huge unwind of trades for those betting against occupancy trends in that area given retailer bankruptcies. Stocks perceived as “safer” – less balance sheet leverage, less business risk – underperformed for the week, and we highlight the Dow Jones Utilities Average being up 2.6 percent for the week as evidence of this dynamic.

Gold and Precious Metals have taken a breather after an impressive year-to-date run, despite the liquidity backdrop. Gold was down 3 percent for the week, silver was down 2.8 percent, platinum was down 1.6 percent, and the HUI was down 4.4 percent. We are impressed by producer capital discipline thus far this cycle, and in several cases are becoming stocks that generalists would find attractive value propositions.

Many have pointed to the better-than-expected jobs report today as having been the catalyst for the broader market rally. While that may be part of it, we believe the financial markets can look through the very likely scenario that the positive unemployment data was driven by the Paycheck Protection Program and the CARES Act. We have pointed out before that the Fed wall of liquidity has backstopped asset prices. It is clear that the environment has turned wildly speculative. Will continued positive surprises on the job front force the Fed to rethink liquidity injections? Will we see a resulting taper tantrum? Right now, speculators have the all clear to force asset prices higher, but experience tells us that despite the fact that the VIX is telling us that “risk” (as defined by volatility, or the standard deviation of asset prices) is coming down, this kind of frothy environment is not likely to end well. We are fond of saying that momentum begets momentum and that the rally is tinder for the rally as investors chase returns. We have seen this movie before.

Best Regards,

David McAlvany
Chief Executive Officer

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