Weekly Market Commentary By H.E.R.O. (26 to 30 April 2021)
Markets declined to close out April with a whimper and were unusually choppy and spooky beneath the surface during the week despite a strong earnings season, which saw Microsoft and Apple down 3.4% and 2.1% despite reporting better-than-expected earnings, as a wave of profit-taking swept across the market, resulting in many popular stocks – both growth and Cyclical – declining over -5% to -15% in frightening wild swings. Over half of S&P 500 companies have reported earnings, with about 87% beating market expectations, the highest level in recent years. Ad-driven Big Tech in Facebook and Google rallied at the expense of Twitter which plunged. Notably, cyclical stocks are dropping on strong earnings reports, and the bellwether large industrial companies that traders monitor closely to get a sense of how things are going in the manufacturing economy – companies which serve dozens of industrial end markets, such as 3M, Carrier Global, GE, Caterpillar, Honeywell, Rockwell Automation, Parker-Hannifin – reported better-than-expected earnings and mostly raising their full-year financial forecasts, and ALL dropped after the earnings came out, with the average decline at ~2%. Cyclical industries tend to lead the market in environments of positive and accelerating economic growth, but falters as growth peaks and decelerates. The market narrative is increasingly inclining towards the “peak earnings” view, resulting in recent retreat in yields and weakness in Cyclicals, though growth companies, with software/SaaS are hit especially hardest by unusual price swings. Notably, the market narrative is shifting towards the view that we’re now in a period where neither growth or Cyclical/Value are “cheap” and the market is increasingly forced to think stock-by-stock where the opportunity is. Meanwhile, the Fed has decided to play the “Good Cop, Bad Cop” game with the market during the week after leaving ultra-dovish monetary policies unchanged following the latest FOMC meeting, with Powell dropping the word “a bit frothy” to describe the stock market and Dallas Fed president adding that “we’ve got real excesses in the housing market” and that the rates should start to rise in 2022. Notably, margin debt and leverage are flashing red: during the 2000 dotcom and 2007 credit booms, US margin debt topped out at roughly 3% of GDP. Now it is at an all-time high of nearly 4%.
Sentiments in Asian markets are weak, with China stuck in an increasingly dangerous range-bound market and turnover near its lowest in six months, as traders remained rattled by policy tightening risks, a record wave of corporate bond defaults, persistent worries over systemic financial risks in Huarong and the earnings delay in China policy banks etc, and Beijing’s unprecedented crackdown on the internet giants. As Beijing prepares to slap Tencent with an antitrust fine commensurate with the US$2.8 billion recently demanded from Alibaba, news that Chinese regulators had summoned 13 internet companies and ordered them to rectify their digital financial businesses and unbundle their financial services dealt another blow to market sentiment. Internet giants who have turned their mobile payment apps into financial supermarkets, offering loans and insurance policies, are told that their “super apps“ should no longer provide financial services beyond payments. The wide-ranging restrictions could weigh further on credit growth. The Hang Seng Tech index/ETF which includes many Chinese tech firms is down over 23% from the February peak. A popular stock with many reputable funds, Tencent Music is down over 45% from the Feb peak; reports that regulators have told the digital music entertainment giant to give up exclusive music rights and possibly sell its key Kuwo and KuGou music apps which would cause irreversible damage to the business. Tencent Music was profitable thanks to its more than 60% share of the local market and 120m paying subscribers, relying on exclusive licensing rights to 20m songs and three streaming platforms — particularly Kuwo and KuGou — for its stronghold. Without that edge, it would be difficult to differentiate its other offerings such as live streaming from smaller rivals. For the 4th time in the last 5 months, China's Services and Manufacturing PMIs missed expectations in April as production and new orders slide. Soaring copper prices have sent crippling shockwaves across China’s economy, with electric wire producers hit the most and the spike is seen slowing the pace of investment by power grids and infrastructure projects. Traders and Beijing policymakers are on edge over the widespread speculative financial demand for copper backing hundreds of billions in Chinese Copper Financing Deals (CCFDs), which raised the dangerous risks of a potential upcoming crash in copper similar to the plunge in oil in the late summer of 2008, when brent collapsed from $150 to $30 right around the time of the Lehman deleveraging.
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.