Fear of Flying

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MR. MICHAEL CEMBALEST:  Good morning everybody.  This is the January 19th Eye On The Market podcast.  Three main topics today; I wanted to talk to you about a bunch of things that are flying.  Equity markets are flying, COVID is flying, and so are corporate reactions to the congressional objectors.  The note this week gets into the details of what's going on with the equity markets.  We've got a lot of fully invested market participants and a complete lack of risk aversion right now and I wanted to walk through some of the details on that.  COVID is flying in certain places around the world as the mutations increase while vaccination is rising at a much slower pace, and I also wanted to talk a little bit about the aftermath of the January 6th, Capitol Building riot, specifically the corporate PACs and the actions they’re taking with respect to the congressional objectors.

Let’s start with equities.  Since last April equity markets have been on a tear.  A lot of the indices, whether it’s the S&P, or the Nasdaq, emerging markets and then specifically alternative energy, semiconductors, consumer discretionary, a lot of these things have been rising at around a hundred percent on an annualized basis since last April.  We expect a rebound in growth and profits and employment this year, but I think investors should start getting a little wary of one directional markets, particularly given some of the uncertainties around COVID mutations and what that might mean.  Our view this year is for rising markets, but with some bouts of intense profit taking along the way, so I would keep some dry powder around.

In this week’s note, one of the things we look at is information from our prime brokerage partners in the investment bank.  In our outlook we talked about very high levels of optimism from individual investors and equity market mutual fund managers.  The prime brokerage covers hedge funds and there were some startling charts in here when you see how quickly the notional exposure and the gross notional exposure of the hedge fund industry has been rising much more quickly than the market itself.  There's been a massive short squeeze.  We have a chart in here that shows the stocks with the highest short interest that have just been soaring this year and also a complete collapse to the lowest level in, let’s say, 20 years or so in the put/call ratio, which is a way of measuring how risk averse investors are by looking at the number of defensive put options the people buy relative to bullish call options, and so the put/call ratio has collapsed.

When you put it together, a lot of market participants fully invested, soaring hedge fund exposures, a short squeeze, and a collapse in risk aversion, I think you have to start being a little bit careful and keeping some spare cash and liquidity aside in case there's a correction at some point.  Now, that said, even though stocks are flying there's still plenty of demand for long duration fixed income as well and one of the things we discuss in this week’s note is how there was a minor 20 basis point backup in yields at the long end that drew in a lot of interest from real money investors, in other words, everybody but the broker/dealers.

An exception to the soaring stocks everywhere you look are the mega cap stocks.  The longest section in our 2021 outlook dealt with the challenges that are facing these big stocks in the form of antitrust issues, rising corporate tax rates, new proposed taxes on low tax jurisdictions around the world from the Biden administration and the digital services taxes being imposed on them by other countries.  We started talking about a lot of these risks last summer and by Labor Day we concluded that the best days of mega cap performance outperforming the market was probably behind them.  That’s exactly what's been happening.

We’ve talked in the outlook about other secular growth stocks that are below the antitrust radar that we like better.  In any case, the events of the last two weeks are also part of what we worried about and like Icarus, some of these stocks have been flying too close to the sun and once you have companies that have enormous size and scope, ever since the early 1900s there has been a reaction by government and by citizens against these enormous concentrations of power.  That said, I’m not going to get into too much detail on the dispute between Amazon web services and Parlor and there's other places you can look for legal commentary about how that dispute may be resolved.

Just so that everybody understands, the challenges that these social media and webhosting companies face in providing a place for people to discuss their views, go pull up Amazon’s response to Parlor’s lawsuit on the internet, Business Insider has a copy, and look on Pages 4 and 5.  Amazon lists some of the things they found people saying on Parlor and I thought this was a pretty nightmarish reflection of the inner id of a lot of the internet users that happen to use those forums.  When you see the kinds of comments that were on that site, you can understand better some of the decisions that Twitter and other platforms took and web hosters took to exorcise themselves of some of those participants.

In any case, I think the best days of the mega cap performance are behind them and we have some tables in here that show how they stack up against the rest of the market and specifically the S&P market cap weighted index has begun to underperform finally, the equal weighted index after outperforming it for so many years in a row.

With respect to COVID right now, the outlook is all about the collision of two things; a good thing and a bad thing.  The bad thing is these new mutations and the good thing is the availability of vaccines to mitigate both the instance of COVID and its severity.  In a lot of the trials that took place, even the people that were deemed to not have had the vaccine work on them quote/unquote, none of those people died or were even hospitalized as far as we know, which means that these vaccines have the potential to mitigate severity of COVID even when people do get it.

We have some charts in here on where some of these new mutations that are taking place.  Even if the new mutations are not more pathogenic, which means deadly, when you get it, they still result in more deaths because if they’re more contagious you have more people getting infected, and then you have this same percentage of infected people dying which means the overall deaths numbers go up.  Will the vaccines work against the new mutations?  Against some of them, apparently yes, based on testing from Pfizer.  Against some of the other ones, we don’t know yet.  There are more mutations to test, one of which originated in South Africa, testing’s underway.  One of the benefits of the mRNA vaccines is that they can apparently be reprogrammed reasonably quickly in order to respond to new mutations, but we’re starting to see mutation breath that is different enough versus the original virus to raise questions about vaccine efficacy, whereas, a few months ago, the mutations were genetically more similar to the original virus itself.

We’ve got some charts in here that look at the pace of vaccination.  They’re plodding along for a lot of the procedural and personnel bottlenecks you read about, and also the reluctance on the part of certain people, including healthcare workers, to take it.  We’ll be talking about some of this with the CEO of Moderna on a webcast this Wednesday, so please dial in if you want to hear a little bit more from him about issues related to personnel bottlenecks, production levels, vaccination levels, and then what they think they can do about resistance and things like that.

One last comment on COVID, one of the most annoying internet fallacies that I see is that COVID deaths are rising but are simply offsetting other causes of death, and so you know, all these other diseases have gone away and so the overall picture is not so bad.  This is just one of the most misinformed idiotic things I’ve ever heard.  The data is really clear.  The CDC tracks deaths from all causes relative to normal levels and anybody with eyes and a brain can look at the chart that we have in the Eye On The Market this week to see that deaths from all causes have surged way above normal levels and the reason for that is COVID.

We've got some additional information this week on the actual fear of flying which is that airline spending is still pretty depressed at about 80% below last year’s level based on credit card spending trends and TSA data, but oil demand overall is rising sharply on the U.S. and elsewhere, and as per our energy paper last June, we outlined a lot of reasons why we expected a rebound in oil and gas demand and related stocks and service sector businesses.  The loss of capital discipline by investors was, in our opinion, rather than stranded asset risks and renewable energy penetration, the primary drivers of why the energy sector did so poorly and capital discipline has unsurprisingly returned after people lost tons of money and the oil sector is rising again, which is more or less what we laid out in our energy paper last June.

We also have a section in here that looks in detail at the reasons why European equities have underperformed in the U.S.  You should take a look.  It’s an interesting chart, because what it does is it breaks down the various different reasons why Europe is underperformed.  A small part of it is the outperformance of the dollar, and a small part of it are sector weight differences where the U.S. has a lot more tech weight and Europe has more financials, industrials, and consumer staples, but the single biggest factor is not currencies in sectors, but within each sector the outperformance of U.S. companies relative to their European counterparts, whether it’s tech, consumer discretionary financials, even within the sectors, U.S. companies are more profitable and have generated higher returns than their European counterparts, so take a look at that.

The last section in today’s note deals with some of the insurrection issues, and I know that a lot of you have been reading in a lot of places a lot of different things, and so I’m not going to repeat what other people have said.  I will say that when I saw what was happening on January 6th, I started thinking about that fly that landed on Mike Pence’s head during the vice-presidential debate, and I started thinking that fly was trying to warn him that Trump was going to betray him in the most Shakespearian manner possible.

Remember, Trump tweeted at 1 a.m. on January 6th, if Mike Pence comes through for us, we will win the presidency.  Pence did not have any, the poor guy had none of the powers ascribed to him by the president, even though under the most distorted and charitable readings of the Electoral Count Act in the 12th Amendment, we explained all of this in detail on a note that we sent to you on January 1st, but enough people believed it and I think a lot of what happened on January 6th was a function of people completely misunderstanding the powers that the vice president has at the joint session and what he chose to do or not do.

Anyway, here we are the day before the inauguration, and the topic I did want to talk about was a bunch of U.S. companies have announced that they are not going to make any more political donations ever to members of congress that objected on January 6th to the Electoral College results.  First, to understand corporate PACs, we have some charts in here that show that all PACs represent somewhere between 20 and 40% of funding for politicians in the house and the senate, the rest coming from self-financing, small individual contributors, and large individual contributors, so PACs overall represent 20 to 40%.  Then within all PACs, corporate PACs are about two-thirds, the rest of them are ideological PACs like the Sierra Club or something like that, and then labor PACs.  All things considered corporate PACs represent 15 to 20% of a lot of politicians in the house and the senate of their funding, so changes to those patterns are material, but not life-threatening, I think is the right way to describe it.

What do I think about the decision to no longer give PAC funding to congressional objectors?  To be clear, this is just my opinion, and it doesn’t play a role in anything except my opinion.  But I think you have to think about it in two ways.  What are the arguments in favor of cutting off donations?  It’s very difficult to find good faith reasons for the objections that took place.  There were not competing slates of electors on the floor.  Some were submitted reportedly to the national archives, but Pence chose not to put them in front of congress.  There were no competing slates of electors on the floor.  Five of six of the disputed states are controlled by GOP legislatures, and none of them officially submitted a competing slate, and then after dozens of court cases, no judge or group of judges ruled that any of the Biden slate should be in any way discounted or decertified.  If you look at it from that perspective, the January 6th objections were attempts to disenfranchise voters with no good reason, and so that’s the reason that some corporate PACs have decided to cut off funding for politicians who objected in the lack of any good faith evidence for doing so.

Here’s the other side.  Irrespective of their reasoning, the congressional objectors were adhering and following rights ascribed to them in the Electoral Count Act.  The bill was passed in 1887 for the purpose of avoiding more violent and disruptive means of resolving these disputes, and so if you punish objectors who use legal means, whether you like it or not, you may be creating incentives for people to channel their objections into illegal means next time around.  As you may have read, democratic house reps raised objections in 2004, in 2000, and in 2016, and whatever their motives were, I don’t think those objections should have been sanctioned at the time either.

Here’s how the process should work from the other perspective.  Objectors should state their reasons for doing so and the supporters of the officially certified slates should say those objections such as those raised by Hawley and Cruz are cynical, unsupported, and baseless, and here is all of our data, court opinions, and legal precedent for saying that, and that’s how politics is supposed to work.  With those arguments in favor of cutting off donations and against them, my own personal opinion is I would not have cut off funding to congressional objectors solely based on their one decision on January 6th, because, as I mentioned, they were exercising rights ascribed to them in the Electoral Count Act in the 12th Amendment.  I would align the corporate PACs with politicians who share their firms values over a wide range of visions over a longer period of time.  That’s my opinion.  For whatever, it’s worth, which is probably nothing.

That is our Eye On The Market podcast for this week.  By the way, the title of this Eye On The Market is Fear of Flying because there's lots of flying references in this week’s note.  If you remember, that was a book written by Erica Jong in the early 1970s, and while it might seem a little tawdry, like a predecessor of the Fifty Shades of Grey books, at the time John Updike and Henry Miller and the New York Times Book Review reviewed it quite favorably.  I was 11 at the time it came out and so I did not actually read it.  Anyway, thank you all for listening, and I look forward to talking to you again soon.

ANNOUNCER:  Michael Cembalest Eye On The Market, offers a unique perspective on the economy, current events, markets and investment portfolios and is a production of J.P. Morgan Asset and Wealth Management.  Michael Cembalest is the Chairman of Market and Investment Strategy for J.P. Morgan Asset Management and is one of our most renowned and provocative speakers.

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