Stocks Bore Me, But People Sure Do Love A Good Bullish Thesis

So the first part of this post is an unedited version of a piece that should be published elsewhere later today.

I wrote two versions, one designed for a more general audience and one that… well… one that was just me playing around and being cynical about stocks and the relative deficiency of Americans’ analytical skills.

The first few paragraphs below are from the unedited version.

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I have a confession to make: I no longer care about stocks.

To be honest, I stopped caring a long time ago.

Stocks are like training wheels on a bike. You have to keep them on until you’re ready to talk about rates, FX, and credit. Most people never take the training wheels off.

Here’s an experiment you should try sometime. Go to a sellside research database and scroll through the section with all the coverage of individual stocks. Note the first names. You’ll see a lot of “Joes”, Ryans”, Patricks”, and “Jasons” (those are real by the way – I actually did this experiment). Then go to the section on rates and scroll through those reports. Again, note the first names. You’ll see a lot of “Harvinders,” “Lotfis”, “Jabazs”, and “Ruslans” (again, those are real). Any guesses on why that is? Hint: it’s not because Anglo-Saxons have a natural affinity for individual stock coverage.

But you know, people like to talk about stocks. It’s a comfort zone thing. So I’ll oblige.

There’s this “great rotation” theory that’s probably bullsh*t. It says that investors, realizing they’re incurring massive paper losses as bond yields rise, will move en masse to equities. Even though equities are absurdly overvalued.

There are a lot of reasons to think this “great rotation” either is a myth or, to the extent it describes reality, isn’t all that “great” after all. When we talk about reasons to doubt the rotation narrative we’re talking about “minor” details like asset allocation rules and regulatory requirements. Oh, and the fact that demand for IG credit is exceptionally robust.

That said, everyone loves a good bullish stocks thesis, so I thought it was worth posting a few excerpts from a Credit Suisse piece that looks at how a rise in inflation could drive equity inflows.

One thing to note at the outset: the idea that because piling fiscal stimulus atop an overheating economy is likely to drive inflation and therefore people will buy stocks, has a major flaw. Namely that if most of the “benefit” from fiscal stimulus goes to inflation and not growth, then it’s exceedingly likely that you’ll get a poor growth-inflation outcome (i.e. stagflation). If the mix of growth and inflation isn’t just right, the correlation between stock and bond returns flips positive. You do not want that in a rising rates environment because it means stocks will fall with bonds. Here’s a handy table from Goldman that illustrates this point quite nicely:

(Table: Goldman)

Consider that as you read the following.

Via Credit Suisse

Perhaps the clearest macro conclusion of a Trump presidency is the upside risk to inflation which will follow his commitment to fiscal easing, border adjustment tax, controls on immigration and more protectionist policies. The unemployment rate, for example, last month fell below the Congressional Budget Office’s estimate of the NAIRU. Despite this, Trump seems keen to pursue fiscal stimulus which, in the context of an economy at full capacity, is likely to generate inflation risks.

In our view, this rise in inflation expectations has the potential to be a catalyst for a significant bond to equity switch given that equities are an inflation hedge, while bonds are a deflation hedge. As the first chart below shows, equity multiples tend to increase as inflation rises, until the inflation rate gets above 3%. Moreover, the correlation between equity multiples and inflation expectations is currently near a decadal high.

This is against a backdrop of investors having spent much of the last decade positioning themselves for deflation, a stance which now appears ill-suited for the emerging macro environment. To quantify this, EPFR estimate that there have been $1.4trn inflows into bonds since 2008 and in aggregate $9bn of net selling of equities.

We continue to believe that a rise in bond yields enables institutions to take more equity risk (as they can meet their defined liabilities more easily) as well as remind retail investors that they can quite easily lose money in bonds. Crucially, retail investors tend to be sensitive to the historical performance of assets, not to valuation. Accordingly, 1999 was a year of strong mutual fund inflows even as the S&P 500 reached an historically high valuation.