Interview

«The Trade for 2022 Is Going to Be an Epic Rotation into Value Stocks»

Larry McDonald, creator of «The Bear Traps Report» and New York Times best-selling author, expects a colossal shift from growth to value stocks in the face of elevated inflation. He also explains why he believes gold and emerging markets have big upside potential.

Christoph Gisiger
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Deutsche Version

It’s the key question for 2022: Will inflation settle at a higher level, or will the surge in prices prove to be only temporary?

For Larry McDonald, the answer is obvious. According to the well-regarded macro strategist and former senior trader at Lehman Brothers, inflation won’t be as high as this past year. Nevertheless, inflation will not return to pre-pandemic levels in his view.

«Emerging market stocks - just like gold - do incredibly well when you have a shortened hiking cycle in the U.S., or if the Fed gets knocked into pausing a hiking cycle.»: Larry McDonald.

«Emerging market stocks - just like gold - do incredibly well when you have a shortened hiking cycle in the U.S., or if the Fed gets knocked into pausing a hiking cycle.»: Larry McDonald.

«If inflation normalizes at a higher trajectory, it’s going to force trillions of dollars out of growth stocks into value stocks», he argues. «The trade for 2022 is going to be an epic rotation into value stocks.»

In an in-depth interview with The Market/NZZ, which has been edited and condensed for clarity, the creator of the «Bear Traps Report» discusses where he spots the best opportunities for investors against this backdrop. He also explains why he believes emerging markets like China have great upside potential and how he bets on the upcoming U.S. midterm elections.

Mr. McDonald, when it comes to the market outlook for the coming year, everything revolves around inflation. What are your thoughts on this issue?

Everybody knows that inflation is going to come down. On a year-over-year basis, these high levels of price increases are just not sustainable. But here’s the problem: If inflation normalizes at 2.5% to 3.5%, or maybe 4%, a lot of money is in the wrong place.

What do you mean by that?

There is a ton of money in growth stocks like Tesla and Nvidia, and what’s happened is that the tertiary parts in this segment have already given away, particularly cloud-software stocks and stocks that are owned by the ARK ETFs. Those stocks are all big deflation bets. But if you have sustained inflation the net present value of future cash flows is worth a lot less for growth stocks, and that’s why they are underperforming. Teladoc for instance, a remote healthcare provider, is down 70% off the highs. Yet, it’s still trading at 14x sales. So if inflation normalizes at a higher trajectory, it’s going to force trillions of dollars out of growth stocks into value stocks.

What does this imply for investors?

The trade for 2022 is going to be an epic rotation into value stocks. That means money managers like Warren Buffett or David Einhorn at Greenlight Capital are going to do really well. In this context, some of our best ideas for next year are names like AT&T and Intel. We also like Alibaba a lot where there is tremendous value. Right now, based on market capitalization, you can fit 9 Alibabas into Apple, whereas this ratio was about 1.5 to just under 2 over the past five years.

Chinese internet stocks such as Alibaba, JD.com and Baidu, which are also listed in New York, have suffered serious losses this year. What makes you so optimistic for 2022?

In years like this, when the S&P 500 is up 15% to 20% or more, the emphasis on tax-loss selling is exponentially higher. It’s a strategy where you dump stocks that have performed poorly in order to reduce capital gains taxes, as the year draws to a close. This year, a lot of investors have index gains and need losses, causing heavy selling pressure on certain names. Now here’s the thing: Historically, the sectors that experienced heavy tax-loss selling typically do very well in the first half of the following year. In our view, we are now past the tax-loss selling season, which gives beaten-down names a very high ceiling lookout. That’s one of the reasons we’re extremely bullish on Alibaba, the China internet ETF KWEB and the China large-cap ETF FXI.

The slump in the Chinese tech sector has a lot to do with regulatory interventions. How do you deal with the political risk?

In China, the credit impulse has been coming down for at least seven months. But going forward, you got the Olympics coming up in February and the party congress later in the year. Taking this into account, we think that president Xi wanted to engineer some event this past year to take out a lot of the bad actors in China’s economy to address excess leverage in real estate developers like Evergrande and fraudulent behavior in other areas like education firms. Basically, he wanted to do a cleanse for everyone to see by punishing tech stocks and highly leveraged entities. But now, heading towards the Olympics and the party congress where president Xi is pressing for a lifetime mandate extension, the last thing in the world China wants is some kind of Lehman situation.

As a former senior trader at Lehman Brothers, you experienced the collapse of the U.S. banking sector firsthand in the fall of 2008. How big is the risk today in China’s financial system?

Here’s what’s interesting: This fall, when Evergrande was collapsing under its enormous debt, China’s currency was very strong, the volatility of the Yuan was really low. Same thing with credit default swaps on the big banks in the Asian region like ANZ Bank, Standard Chartered and HSBC. In periods where there is real stress in China, as in 2015 with the devaluation in the Yuan, CDS on Western banks near China have been a highly reliable leading indicator, a canary in the coalmine type. In the face of this year’s incredible deleveraging process, it’s shocking how tame the volatility in the Yuan has been. China’s currency has been strengthening, and it’s remarkable how there really hasn’t been any credit contagion the way there was in 2015. And now, with the Olympics and the party congress coming up, the probability of a fiscal impulse is extremely high.

So you’re betting on new stimulus for China’s economy?

Remember, we had back-to-back capitulations in Chinese equities over the past year: China had a pretty nasty Covid outburst in Q3 and then they had this kind of regulatory punishment period and the deleveraging. What’s more, there is a lot of uncertainty regarding the threat of delisting Chinese companies in the United States. But we think that’s overblown, at least for now. The delisting risk makes a lot of noise, but it’s really two to three years away. So from our capitulation model’s point of view, these stocks are a screaming buy.

How exactly does this model work?

It’s a seven-factor model where we look for things like the distance of the share price below the lower Bollinger band or the amount of shares traded in the most recent weeks vs the last six months, the last year and the last five years. In the case of ETFs, we’re also looking at the discount to net asset value, and with equities at price-to-earnings and price-to-sales ratios. In essence, the model mathematically tries to calculate seller exhaustion. A textbook example was the historic capitulation in the energy sector in 2020. First, it was driven by Covid, and then by the Democrats basically promising that they were going to wipe out the oil and gas industry when they took control of the White House and Congress. As a result, you had two events that shook investors out of energy stocks, and the capitulation score was the highest ever.

Accordingly, you favored oil and gas companies in our interview at the time. How do you view the prospects for energy stocks today?

We’ve trimmed our energy position by 30%, but we’re still bullish. For instance, I’m looking at Buffett and he basically bought one stock in the third quarter: Chevron. I’m with him, and I love Chevron here. It’s a cheap stock with a great dividend. Besides Chevron, we have the energy ETF XLE and BP in our core holdings. Next year, it’s going to be really busy because the social response to Covid will be so powerful. It was already powerful this year, but if you listen to the American Express earnings call, global business travel is still 40% off the highs. This coming summer, I expect a big revival in business and leisure travel, and that’s going to be very bullish for energy because we just don’t have enough oil relative to global growth.

Where else do opportunities open up?

We also love Brazil. Think about what Brazilian banks have been through: In 2016, you had a huge inflation scare in Brazil and a commodity bust pushing the country into a horrible recession. On top of that, Dilma Rousseff, Brazil’s president, was removed from office. Hence, the period of 2016 to 2018 was a horrific event where Brazilian stocks were destroyed. And then, Brazil got hit hard by Covid. So if you’re a Brazilian bank and you’re still standing, you’ve just survived two colossal historic shocks. As a result, from an upside/downside perspective you have tremendous value. The EWZ ETF which tracks an index of companies in Brazil is another case where you have a very decent capitulation score. And here’s the most important part: Emerging market stocks - just like gold - do incredibly well when you have a shortened hiking cycle in the U.S., or if the Fed gets knocked into pausing a hiking cycle.

Why do you think that will be the case? The Federal Reserve signaled just a few weeks ago that it intends to raise benchmark interest rates three times next year.

Let’s take a quick look back: In the post-Lehman era, the Fed hiked rates nine times. And, if you add in quantitative tightening - the rundown of the Fed’s balance sheet - they actually hiked rates 15 times between December 2015 and 2018. That’s because quantitative tightening has a very similar power as rate hikes. In addition to that, we had the taper period in 2014. So actually, the tightening cycle was 2014 to 2018. Put differently: We had a five-year tightening cycle, and typically emerging market stocks and gold do very poorly through a long-embedded hiking cycle.

What does this mean for the current cycle?

The market is starting to act funny. People are starting to sell the rallies instead of buying the dips. What’s happening is the beast in the market is looking at all this monetary tightening and a fiscal cliff. Over the last two years, investors had three safety blankets: One them was monetary accommodation. The second one was a huge fiscal tailwind: In the U.S, we had $6 trillion of deficit spending in 2020 and 2021. And thirdly, the vaccines were coming on the scene giving people a lot of hope. But now, the beast in the market is looking at $3 trillion of fiscal and monetary withdrawal, and on top of that, there is uncertainty around the effectiveness of vaccines. This is setting up for a real problem because inflation plus the fiscal and monetary withdrawal equals a tremendous amount of tightening.

Fed Chairman Powell, however, continues to say that the U.S. economy is on a robust growth path.

It’s pretty obvious: Eurodollar futures and the long end of the yield curve are telling you: «No way on God’s green earth will this hiking cycle go on for five years and 15 hikes.» I think inflation already hiked rates for the Fed by around 150 basis points because of demand destruction. For regular families spending money on Christmas presents and food for the holidays, the costs have just doubled. It’s also everything that goes into oil and chemicals. So the consumer is really wounded. For instance, if you look at University of Michigan data, the Fed has never ever kicked off a hiking cycle with consumer confidence as low as it is now. Bottom line: This shortened hiking cycle is going to be a home run for gold and stocks in emerging markets like China and Brazil. That’s the big trade for 2022.

Source: «The Bear Traps Report»

However, there is already speculation on Wall Street that the Fed will not only tighten interest rates soon, but could also start reducing its balance sheet towards the end of 2022.

This is like tapering on steroids: You can’t accelerate the taper, promise three rate hikes and a possible quantitative tightening without destroying growth stocks. We think the Nasdaq 100 will see a brutal correction until the Fed backs away by summer. In this environment, the safety net for investors is that value stocks are going to outperform. That’s why we love names like Intel. It’s one of our top ideas in our tax-loss basket for next year. Personally, I’m short the semiconductor sector ETF SMH and long Intel. If you look at the outperformance of the semiconductor sector vs Intel, it’s mathematically unsustainable. It’s off the charts by two to three standard deviations outside the norm. And with Intel, you have a dividend of 2.5% to 3% which means double the yield compared to ten-year Treasuries. Another interesting part is that Seth Klarman and Dan Loeb - two hall of fame investors - own the stock.

Why do you think the Fed will back down? And what does that mean in terms of rate hikes?

They will probably hike once next year. Central bankers are very bright people, but they are academics who never have managed risk. So they put forth these altruistic, pollyannaish policy proposals. Look at the amount of debt on the planet. It’s bad, and everybody understands that, but the real problem is not just more debt. What’s important is that there’s $30 trillion of debt that yields less than 2%. So when interest rates move up, bond prices move down, and you have a lot more downside on a 2% bond than on a 4% bond.

Speaking of debt: What’s in store for the markets in 2022 in terms of U.S. fiscal policy? President Biden’s Build Back Better stimulus program recently suffered a major setback.

That was a call where I was wrong. But we did get the infrastructure bill, and we got the American Rescue Act in March. So President Biden did pass two meaningful pieces of legislation. He couldn’t pass Build Back Better, and right now the market believes there’s nothing coming. But I do think that this new Covid wave increases the probability of more stimulus. It won’t be called Build Back Better, but if there is enough downside in the market and enough stress in the system, we will get a capitulation from the Fed where they will alter the rate hike schedule and we will get a capitulation from Washington around more fiscal spending. That’s the big call for next year: By mid-July, we probably will have a fiscal and monetary capitulation.

In Washington, the focus will increasingly shift to the mid-term elections in November as the year progresses. Which sectors could benefit in this environment?

In this regard, one sector where the risk/reward is one of the best we’ve ever seen is cannabis. Our bull case for cannabis is based on the fact that there has been this incredible ground swell of passive money that’s come into ETF providers like BlackRock and Vanguard. Those ETFs stood at $7.71 trillion under management at the end of last year, narrowly behind index mutual funds at $7.76 trillion. And, with a passive ETF there is no real choice. They have to buy the stocks in a given benchmark. Hence, these massive flows into passive strategies have been one of the reasons why the S&P 500 has been so strong.

But what does this have to do with cannabis?

From an investment standpoint, it’s not so much about getting high, but about getting well. The real upside will come from medical advancement; dozens of potential drugs will be developed based on the cannabinoid molecule over the next five to ten years. Today, there are 36 states in the U.S. where the medical use of cannabis is legal, but it’s still illegal on the federal level and that’s creating a mess. In this context, a growing number of Republicans are now supporting decriminalization. Bottom line: Over the last five years, we’ve seen a significant and very consistent secular sentiment change coming out of Washington. It’s kind of coming out of prohibition. There is so much momentum that it’s unstoppable.

So what does this specifically imply for investments?

I’ve been doing this for a long time, and there are certain sectors where you have political cycle shifts and stocks will go up in euphoria. That’s what happened with cannabis stocks in the first quarter. They were 50-60% higher than they are now, because of the euphoria when the Democrats took control of all three branches of government. But then, you had a whole bunch of things like the infrastructure bill and Build Back Better jumping in front of cannabis legalization. As a result, that huge amount of hot money that came into cannabis stocks at the beginning of the year got totally flushed out, a horrific capitulation. Right now, these stocks are trading at 2-4x sales after they were trading at 10-20x sales. To put this into perspective: The cannabis companies that operate in multiple states are growing their top-line at similar rates to the fastest growing tech companies and are trading at fractions of the valuations.

Are you saying cannabis stocks are a steal?

Here’s the sizzler: Democrats will control all three branches of government for certain next year. But because of the midterm elections in November, there is a high probability that they will move on cannabis quickly. Keep in mind, you almost never see legislation coming out of Washington after April 1. It just doesn’t happen because members of Congress go back to their districts and they don’t want controversy in front of the elections. That’s why the probability of the Democrats moving on cannabis in the first quarter is very high.

And where is the connection with passive investments?

Today, passive asset management cannot play in the cannabis sandbox because it’s still illegal. For instance, the US Cannabis ETF MSOS doesn’t own the stocks. Instead, it has structured contracts in there that give the ETF participation, getting around the system. But if cannabis is decriminalized on a federal level, then the BlackRocks and the Vanguards of the world will start to create cannabis ETFs. So let’s do the math: If 0.5% to 1% of passive assets move into cannabis over the next 5 years, we see returns of 200% to 300% on the upside for U.S. cannabis equities.