Weekly Market Commentary By H.E.R.O. (21 to 25 Jun 2021)

Major U.S. stock indexes reach new highs and the 10-year Treasury yield headed for its biggest weekly increase since March as reflation trades regained appeal after U.S. President Biden sealed a $1 trillion bipartisan infrastructure deal with legislators, down from the $2.3 trillion Biden initially hoped to secure. The new infrastructure bill will include $579 billion in new spending, and when combined with the renewal of existing funding pushes, will equate to $973 billion in spending over five years. However, below the market's exuberant surface, there is sheer panic as option skew index soars to all-time high, indicating expectations for big stock market gyrations over the next three months ahead of key economic data and corporate profit reports, reflecting that they have never been more nervous that even a modest wobble in the market could starts a crash and that stocks would become increasingly correlated with each other in a sell-off. Short interest in the SPDR S&P 500 ETF Trust has also increased to its highest level this year to 5% of its stock outstanding, from less than 2% at the start of this year, suggesting investors have been adding more downside protection. Gains this month have been more concentrated, as investors piled back into the big technology stocks, but the average S&P stock has lagged, with the equal-weighted S&P 500 up just 0.3% in June and the average stock in the benchmark was 8.9% off its 52-week high, which some investors view as a sign of waning confidence in the broader market. Noteworthy is the double-digit crash over the last month in the consumer discretionary “suburbia” trade from e-commerce platforms to home improvement stores to furniture and housewares merchants. Homeowners have spent the expected premium on their home’s price well in advance, with about $152.7 billion in equity loans taken out on U.S. houses last year, a massive increase of 41.7% from 2019 and the highest refinancing cash-out dollar amount since 2007, indicating that there’s real risk American homeowners may be overly optimistic about what their homes are worth — and a chance this home equity loan free-for-all simply isn’t sustainable for much longer. The “suburbia” trade is part of the top quant strategy which posted its worst monthly decline since 2002 and the biggest monthly drawdown on record after last week’s FOMC.

Investor concerns include the debate about whether rising inflation will be sustained enough to force the Fed to begin a sooner-than-expected rollback of its easy-money policies. A survey now finds “central bank policy error” is the third biggest risk to the market, behind higher-than-expected inflation and bond yields, and new variants to the coronavirus that bypass COVID-19 vaccines. As business rebounds from the coronavirus pandemic, the second quarter is also expected to mark the peak for U.S. economic and corporate profit growth, which could bring market unease as growth slows. Some investors also believe the S&P may be overdue for a significant pullback. Since World War II, the index has had a decline of at least 5% an average of every 178 calendar days. The latest market advance has lasted 276 days without such a fall, the longest period since January 2018, when a 715-day advance was followed by a 10.8% drop for the S&P 500. In the annual Russell (1000, 2000 and 3000) rebalance on Friday, dubbed the "biggest trading event of the year", the proportion of money-making companies in the index will fall to the lowest since 2000, or the number of money-losing "zombies" in the Russell will be the highest it has been this century. Meanwhile, new banking rules, part of the sweeping international Basel III accord, will come into effect on Monday and mark a big change for European banks and their dealings with gold. Allocated gold, in tangible form, will essentially be classified as a zero-risk asset under the new rules, but unallocated or “paper” gold, which banks typically deal with the most, won’t — meaning banks holding paper gold must also hold extra reserves against it. Banks could be “discouraged” from dealings in gold forward contracts in London and in futures contracts on Comex, which could lead to “greater gold price volatility.

Defaults in China this year have exceeded a record high of $23 billion, ahead of the Communist Party’s 100th anniversary on 1 July. With the outbreak spreading to the manufacturing hub of Dongguan, Beijing expanded its lockdown with mass testing launched in the city. The southern coastal province of Guangdong appears to be the epicenter of new coronavirus cases as Shenzhen airport has canceled hundreds of flights and tightened entry controls. Meanwhile, four months into new Chinese “three red lines” guidelines, indebted real estate developers continued their windows dressing with record issuance of sizable off-balance-sheet dollar bonds, and convoluted joint-venture corporate structures were deployed to hide debt in order to meet Beijing’s new financing rules. Minority interests now account for 39% of a median company’s total equity, when these equity stakes should be reclassified as short-term debt, and some bond traders began dumping companies that relied on joint venture partners as important funding sources.

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. 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.