Weekly Market Commentary By H.E.R.O. (19 to 23 April 2021)
Markets bounced on Friday to pare back losses for the week, as traders digest a triumvirate of events weighing on market sentiments: (1) Biden’s capital-gains tax hike, (2) Double-mutation virus surge in India and Japan, (3) Netflix’s dismal quarterly results with horrific plunge in subscriber growth and weak guidance. Long-term capital gains and qualified dividends are currently taxed at a maximum rate of 20%, along with a separate 3.8% tax on investment income. Biden wants to tax these as ordinary income for filers with over $1 million in annual income. This would roughly double the tax rate on capital gains and dividend income from 23.8% to 43.4%. The wealthiest households now hold around US$1 trillion in unrealized equity capital gains. This equates to 3% of total US equity market cap and roughly 30% of average monthly S&P 500 trading volume. Markets rebounded with the view that most Americans hold most of their stocks through tax-privileged vehicles such as 401(k) plans, and are unaffected. In addition, the trend of net equity selling and falling stock prices around capital gain rate changes has usually been short-lived and reversed during subsequent quarters. In 2013, although the wealthiest households sold 1% of their assets prior to the rate hike, they bought 4% of starting equity assets in the quarter after the change and therefore only temporarily reduced their equity exposures in order to realize gains at the lower rate. Total household equity allocations demonstrated a similar pattern around the two preceding capital gains tax hikes. Earlier, there’s a feeling in markets that we could be set up for a potential multi-year demand recovery story globally and that could potentially be analogous to the post-World War II period. There are increasingly growing doubts and apprehension over the reflation/reopening narrative, that the economic benefits of building big physical infrastructure projects take time to have an effect but the taxes to pay for them have an immediate and earlier impact.
Earnings season is ramping up next week onwards, reshuffling the deck of the winners and losers. While it’s still early in the earnings period, a record percentage of first-quarter profit reports from major U.S. companies are coming in above analysts’ expectations. With results in from 110 of the S&P 500 companies, 85.5% have beaten analysts' estimates for earnings per share. If that trend continues through the reporting season, it would be the highest beat rate on record going back to 1994. However, earnings are seen rebounding from the base of last year's pandemic-fueled lows, and many companies were holding off on giving guidance at all, resulting in the earnings signal to be mixed. The spotlight was on Netflix and stay-at-home darling stocks, after Netflix reported that it added only 4m subscribers in the first quarter, a sharp slowdown from its pandemic-driven gains last year, as the US began to emerge from lockdown. At the end of March, the streaming giant had 208m customers globally, falling short of its own guidance for 210m. Netflix said it also expected the second quarter to be slower, projecting only 1m subscriber additions and a “roughly flat” customer base in North America, its largest market; Netflix added more than 10 million new subscribers during the same period in 2020 and estimates for subscribers was 6.4m. Meanwhile, the global market capitalization of loss-making companies (those who had reported a negative profit number in the last year and in each of the last three years) is higher than at any point during the past 22 years, and has even surpassed the dot com bubble.
Notably, households already have the highest share of their assets in stocks in more than 50 years, with household equity holdings accounting for 47% of their total assets. The data suggests that as households grow more invested in stocks, returns decline. The last time investors were this heavily invested, in 1970, the S&P 500’s annual return compounded over the next 10 years was below 5%, compared to the S&P’s historical average annual gain in the high-single digits. Returns were negative in the decade after 1999, when equity holdings relative to total assets hit another peak. Noteworthy is that the net flow of U.S. money going into stock funds focused on assets outside the U.S. has been more than twice as large as that into U.S. mutual funds and ETFs in 2021. At the same time, speculative excesses continued to sizzle in the darker corners, with the prominent example in Hometown International, the owner of a humble deli in New Jersey that recently topped a $100 million market valuation despite only registering US$21,772 in sales in 2019 and US$13,976 in 2020 when it was closed due to COVID.
Meanwhile, U.S. Congress is moving with increasing urgency on bipartisan legislation to confront China and bolster U.S. competitiveness in technology and critical manufacturing with the Senate poised to act within weeks on a package of bills, raising further tensions in the U.S.-China relationship. Investors are dumping U.S.-listed companies that do business in China, with the Fathom's China Exposure Index (CEI) declining sharply in April amid China's credit growth moderating, Beijing's crackdown on internet giants and escalating tensions between the US and China. Firms in the CEI derive between 15% and 85% of their revenues from China. The combined value of stock shorts on the Shanghai and Shenzhen stock exchanges climbed to 152 billion yuan (US$23.4 billion) during the week, according to data published by state agency China Securities Finance. That’s the highest since local brokerages were allowed to officially start securities lending and borrowing in 2010, reflecting demand for hedging against the risks of policy tightening and further fallout from the nation’s antitrust crackdown on technology companies. Desperate for short-term funding, some major shareholders of a slew of companies have recently agreed to lend their shares to China Securities Finance, a state-backed agency to aid brokerages’ leveraged trading and short-selling businesses, adding to the supply of stocks that can be shorted.
The portfolio stocks remain well-anchored to very strong and powerful fundamentals with clear and visible growth prospects and positive corporate development progress and robust end markets, and are very likely to rebound resiliently from the speculative sentiment-led rotation and frenzied positioning once the 1Q2020 earnings reports start from mid-April onwards, and it’s a great opportunity to accumulate existing stocks and potential new companies.
As euphoric traders piled into the trendy Cyclicals, Value Traps, we believe that there is a high probability of downside risk in chasing and catching them at exactly the wrong time after their sharp run-up from being blinded by the fiscal stimulus hopes and vaccine euphoria — the light at the end of the tunnel — and things can turn very nasty suddenly, as markets tend to underestimate how long that tunnel is, and how dangerous that tunnel is. This situation is very vulnerable for cyclicals to degenerate or revert back into its true ugly colors as cheap-gets-cheaper Value Traps once the vaccine euphoria fades or something negative happen on the mass vaccination roll-out or the vaccine does not prevent people from carrying and spreading the virus to others or new mutated virus strains erupt to render the vaccines ineffective.
Once the vaccines actually start being administered at scale and the pandemic recedes, a lot of investors are going to wake up to the fact that the global economy is still dogged by a host of thorny problems that both predate and have been exacerbated by the virus. The current unsustainable market euphoria over Cyclicals, Value Traps, Zombies (companies who cannot cover their interest expense with cash from operations) and Vampires (junk-rated corporations with negative EBITDA) has created opportunities for long-term investors in the inexorable rise of a selected group of fundamentals-based structural growth innovators who have remained resiliently positive throughout the most extreme ever market rotational change since November 2020, setting the roadmap this year and beyond in a post-pandemic future. These winners solve high-value real-world problems to generate visible and vigorous quality earnings growth before and during the pandemic, as well as are poised to enjoy continued healthy demand and staying power in a post-pandemic future when the world recovers painfully and slowly to transition from the Pandemic Health Crisis to the next crisis – the PTSD Post-Pandemic Growth Crisis.
Our portfolio companies have shown resilience and scalability during this tumultuous environment and the management continue to make key strategy decision to expand their market leadership in their respective fields. The quiet HE.R.O. innovators have invested wisely in innovations that sharpen their exponential competitive edge for long-term value creation, strengthened their market position in the value chain that supercharged their cashflow dynamics, developed new channels, new markets and new customer base for revenue growth while improving their profitability at a time when most businesses are struggling, and nurtured their human capital and corporate culture to foster innovation and ESG sustainability.
While the short-term day-to-day price movement can be volatile, what continues to be crystal clear is that the quiet structural growth H.E.R.O. innovators remain the most visible and vibrant pathway in a foggy, volatile, whipsawing, uncertain market to deliver sustained outperformance with their healthy fundamentals results.