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What Year is it?

Banks and Oils are staging a Comeback
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What Year is it?

Banks and Oils are staging a Comeback

Hi Everyone 👋,

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While the decimation of spec tech has dominated headlines, there have been two industries that have not only escaped the sea of red but have been thriving in the chaos: Energy and Financials.

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Admidst all the doom and gloom, we have to remember that the S&P500 is only down 8% from all-time highs. As much as it seems like as goes megacap tech, so goes the market, that is not always the case. There are other fish in the sea, and these are still big fish.

For years, those involved in the Oil & Gas business have taken an absolute beating while talking heads call the trade dead. But at the end of the day, we simply need to fill our energy consumption with supply that is available today instead of some long term hope and prayer of 100% renewables all the time.

On the financial side, before 2021 major U.S. banks traded mostly sideways in a holding pattern ever since the 2008 crisis and subsequent recovery. In a rising rate environment, should banks continue to get a bid? Or is their recent run-up overdone to the point where even multiples amongst these stalwarts of “value” are looking a little stretched?

This week, in <5 minutes, we’ll cover the Energy and Financial value plays:

  • Macro Backdrop 👉 Rising rates combined with high growth and inflation

  • Cyclical vs. Defensives 👉 How each are expected to perform in different market conditions

  • A Note on Correlation 👉 Industry correlations with rate movements

  • Financials as an industry 👉 Why rates matter

  • Energy as an industry 👉 I thought Oil was in secular decline?

  • Here for a good time? or a long time? 👉 Looking at current price action and multiple expansion

Let’s get started!

1. Macro Backdrop 👉 Rising rates combined with high growth and inflation

Two weeks ago, I wrote in-depth about how contractionary monetary policy, leading to an increase in interest rates impacts technology stocks. But this doesn’t tell the whole story. We also need to take a look at what is going on in the “real” economy.

For this section, we’re going to dust off our Econ 101 books and then take a look at what the best and brightest on the street are saying.

We are all aware by now of the drastic increase in money supply that the fed had to unleash in order to save the economy from collapsing. The two charts most relevant to seeing the magnitude of the money supply increase are these:

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M2 is important because it includes cash, checking deposits, and easily-convertible near money. The more money “in the system” the higher the demand for all goods within this system. More money chasing the same amount of goods. That alone is a problem. But we don’t have the same amount of goods. In addition to more money chasing goods, we also have supply chain bottlenecks leading to far fewer goods in the system as well, which has lead us to inflationary readings not seen for 30 years.

Papa Jay Powell initially was very clear that this inflation was transitory but we know now that this is not the case. Inflation has persisted and will continue to do so over the near term. In our Fed piece a couple weeks ago – we highlighted that the feds main two jobs are controlling inflation and obtaining reasonable levels of full employment in the economy.

When you have inflation run amok, the Fed has to step in, and market economists are now pricing this in to the tune of 4 rate hates (25bps each = +1%) in the current year. But there is a very divided camp on the longevity of inflation, its impacts, and where rates can go from here.

We know they’re going up – but the uncertainty in magnitude and logevity that is currently being priced into the market is crushing growth stocks. If the market hates one thing its uncertainty, and there’s plenty to go around right now.

In one camp – we have the inflationistas who make the argument that we now are in a cycle where we will need permanent quantative easing in order to see much of any growth which will lead to long-term inflationary pressures. In the other corner, the likes of Cathy Woods are touting the level of globalizationand the productivity factor of technology to be permanent deflationary pressures.

The truth lies somewhere in between, and we need to watch CPI levels, employment levels, and listen carefully to the Fed conferences in order to ascertain any indication of which direction this can go.

Under the Radar

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LEADING FOOD INNOVATION. MeliBio, a CULT Food Science portfolio company, just received the JUST Food Magazine Excellence Award in the Innovation category! Previously, it was featured in TIME’s 2021 edition of “Top 100 Inventions of The Year”. And they’re not done yet: the bee-free honey-producing trailblazer is expanding production and hiring top scientists to develop delicious new flavors*!

OWN THE CUSTOMER. Rivalry is already growing at break-neck speeds and with $41M cashed up they’re positioned for more aggressive growth (Australia in Q1 and Ontario in H1). How are they doing it? Rivalry is deeply woven into the fabric of Internet culture, which means they own their customers, rather than renting them with outsized spending*.

INCUBATING TECH GIANTS. Sears, then Amazon. Blockbuster, then Netflix. BlackBerry, then Apple. It’s the circle of life (read: capitalism). That circle now spins tighter than ever which means the next big tech giants are already being built, and the best-in-class are doing it at Victory Square, where investors get ground floor access and have given away 3 dividends with plans to give away more*!

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2. Cyclical vs. Defensives 👉 How each is expected to perform in different market conditions

When looking at the expansionary and contractionary economic periods, its helpful to take a page from Ray Dalio and think of these periods in terms of waves.

Ray Dalio's Economic Machine — 12 Minute Summary

What we essentially get from an economy throughout its growth period are mini cycles within “the cycle.” These mini cyclical waves ebb and flow but the general trend is up and to right as productivity growth prevails as the dominating long-term factor.

Within these mini-cycles, it is beneficial to acknowledge the general characteristics of sub-industries and their exposure to these cycles. We can roughly split industires into: cyclical and defensive.

Cyclical companies move in tandem with the respective economic stage of the cycle: expansion, peak, recession, and recovery. These industries are directly impacted by the willingness and ability of the consumer to spend their disposable income or by a business to use goods and services on an advantageous cost basis. Cyclical stocks have boom and bust cycles, leading to more volatile fundamentals. Cyclical industries include banks, energy, and consumer discretionary.

Defensive companies are quite the opposite. They are much more resilient in that they do not fluctuate as greatly with economic cycles. In a recession, very few people are skipping their medicine or are able to skip rent in the event of an economic downturn. These act as good buffers that produce more stable fundamentals, with less volatility. Examples of defensive industries are utilities, consumer staples, and healthcare stocks.

On top of the terms value/growth which we will address below, it is also important to keep in mind defensives and cyclicals.

3. Cyclical vs. Defensives 👉 How each is expected to perform in different market conditions

When trying to understand grand ideas – you have to have knowledge of how the underlying subsectors react to macro events. One way to do this is to look at historical correlations between movements and stock price action. Correlations are never perfect because nothing ever happens in a vacuum, and there are far more variables at hand that can ever be fit into linear regression equations. As the famous saying its stats goes… correlation does not equal causation.

However, correlations can be used as an initial road map when trying to build out the entire story. In a raising rate environment, here is one of the most important graphs when thinking about sector allocation:

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But we also have to understand the underlying characteristics of these sectors. For the purpose of this newsletter, I will cover two industries that have had a massive run this year, despite all the doom and gloom headlines: Banks and Energy (particularly oil).

4. Financials as an industry 👉 Why rates matter

A rising rate environment is typically an indication of an overall strengthening economy. That health usually means that borrowers have an easier time making repayments and banks have fewer non-performing assets.

When the FOMC acts to increase the federal fund rate, it creates a ripple effect throughout the economy. Since the benchmark rate is the federal fund rate, any increase in this will elevate all short-term borrowing costs for financial institutions.

Since these institutions have to then go out and lend this money to consumers (through anything from credit cards, mortgages, etc…), a majority of this is passed on to businesses and end consumption of goods and services.

This means that banks can earn more from the spread between what they pay (to savers for savings accounts and certificates of deposit) and what they can earn (from highly-rated debt like Treasuries).

The financial sector has been positively correlated to an increasing rate environment because profit margins expand as rates climb.

Insurance stocks can also flourish as rates rise. The relationship between interest rates and insurance companies is linear, meaning the higher the rate, the greater the growth. These same insurance providers don’t fare as well in low-rate climates because their underlying bond investments yield weak returns.

Insurers, which have steady cash flows, are compelled to hold lots of safe debt to back the insurance policies they write. In addition, the economic health dividend also applies to insurers. Improving consumer sentiment means more car purchasing and improving home sales, which means more policy-writing.

5. Energy as an industry 👉 I thought Oil was in secular decline?

The recent move in energy prices has more to do with the characteristics of the constituents. After a prolonged period of lagging the market, energy stocks have moved into deep-value territory. When the industry is viewed to be in secular decline and a wave of ESG criticism come to the forefront, capital shies away from these equities.

But there comes a point where cheap is too cheap. When flows came out of growth, they went into value, and the rotation has been violent.

Oil is one of those industries where there are an infinite amount of inputs from a demand and supply perspective because of how global and strategically political it is. If we look at reasons for the increase in the price of oil over the last couple of months, you can point to: Russian/Ukraine conflict, Iranian supply, Oil inventories below normal leading to an undersupplied spot market, demand remaining firm despite Omicron, rising inflation, higher rates, growth/value rotation, etc… etc…

I like to keep it simple…since a rising rate environment is one where there is usually economic growth, Oil as an energy input that powers the economy usually tends to rise with this growth. I do believe that Omnicron is the last we’ll see of covid, supply chains will be alleviated, and we’ll see transportation’s demand for fuel accelerate.

Obviously, Oil and Gas stocks are directly correlated with the price of one barrel of Oil because producers sell at that cost, while trying to keep production costs low. I’ll leave the rest of the Oil market commentary to the thousands of other experts.

But I will leave you with this long-term chart to help you answer: “Should I hold energy stocks over the long run?”

6. Here for a good time? or a long time? 👉 Looking at current price action and multiple expansion

While the current environment looks like it will continue to support value assets at these levels, the recent run-up is starting to look a little bit stretched. When you have Microsoft trading cheaper than Costco, and Google trading cheaper than Coca Cola (on a P/E basis), the runup in value starts to almost declassify these stocks as value stocks.

Will the long-time reigning champion of growth finally be outshined by the cigar-butt likes of value? Time will tell over the coming years, but to wrap, I’m just going to leave this here…

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If you want to hear more from us – make sure to subscribe to our *NEW* weekly livestream show HERE!

Until next time. Always Yours. Incessantly Chasing ROI,

-Genevieve Roch-Decter, CFA

What else we Grittin’ On?

NEW-HOME SALES SURGE. U.S. home prices rose 18.8% YoY and sales of new homes reach a 9-month high in December. At this point, Millennials will settle for a decent affordable starter home in the metaverse.

NEW IPO ALERT. Delivery service GoPuff is working with banks for an initial public offering in the second half of 2022. Many companies half been getting cold feet on public offerings amid volatile market conditions.

THE TORTOISE VS. THE HARE. Cathie Wood's ARKK had a historic year in 2020, but Warren Buffet's Berkshire Hathaway has just surpassed the innovation fund in post-pandemic performance! Buy great companies and never sell.

BLOCKCHAIN ETF. BlackRock has plans to launch a blockchain ETF to invest in companies involved in the development and usage of crypto tech. It's still early.

PLACE YOUR BETS. The first 4 mobile sportsbooks in New York have surpassed $600M in wagers. The city legalized betting on your phone less than 3 weeks ago.

Sources:

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Disclaimer:The publisher does not guarantee the accuracy or completeness of the information provided in this page.  All statements and expressions herein are the sole opinion of the author or paid advertiser.

Grit Capital Corporation is a publisher of financial information, not an investment advisor.  We do not provide personalized or individualized investment advice or information that is tailored to the needs of any particular recipient.  

THE INFORMATION CONTAINED ON THIS WEBSITE IS NOT AND SHOULD NOT BE CONSTRUED AS INVESTMENT ADVICE, AND DOES NOT PURPORT TO BE AND DOES NOT EXPRESS ANY OPINION AS TO THE PRICE AT WHICH THE SECURITIES OF ANY COMPANY MAY TRADE AT ANY TIME.  THE INFORMATION AND OPINIONS PROVIDED HEREIN SHOULD NOT BE TAKEN AS SPECIFIC ADVICE ON THE MERITS OF ANY INVESTMENT DECISION.  INVESTORS SHOULD MAKE THEIR OWN INVESTIGATION AND DECISIONS REGARDING THE PROSPECTS OF ANY COMPANY DISCUSSED HEREIN BASED ON SUCH INVESTORS’ OWN REVIEW OF PUBLICLY AVAILABLE INFORMATION AND SHOULD NOT RELY ON THE INFORMATION CONTAINED HEREIN.

No statement or expression of opinion, or any other matter herein, directly or indirectly, is an offer or the solicitation of an offer to buy or sell the securities or financial instruments mentioned.  

Any projections, market outlooks or estimates herein are forward looking statements and are inherently unreliable.  They are based upon certain assumptions and should not be construed to be indicative of the actual events that will occur.  Other events that were not taken into account may occur and may significantly affect the returns or performance of the securities discussed herein.  The information provided herein is based on matters as they exist as of the date of preparation and not as of any future date, and the publisher undertakes no obligation to correct, update or revise the information in this document or to otherwise provide any additional material.

The publisher, its affiliates, and clients of the a publisher or its affiliates may currently have long or short positions in the securities of the companies mentioned herein, or may have such a position in the future (and therefore may profit from fluctuations in the trading price of the securities).  To the extent such persons do have such positions, there is no guarantee that such persons will maintain such positions.

Neither the publisher nor any of its affiliates accepts any liability whatsoever for any direct or consequential loss howsoever arising, directly or indirectly, from any use of the information contained herein.

By using the Site or any affiliated social media account, you are indicating your consent and agreement to this disclaimer and our terms of use. Unauthorized reproduction of this newsletter or its contents by photocopy, facsimile or any other means is illegal and punishable by law.

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