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Monthly Market Commentary

| December 02, 2022
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Revenge of the old economy.  I think that will be the theme for the next cycle.  With inflation cooling, Atlanta Fed GDPNow showing 2.8% growth for the fourth quarter, and China taking steps to open up, investors now have a chance to take a step back and think about what the new leadership will be.  Every cycle has new leadership, while the previous leadership underperforms.  The Nifty Fifty stocks of the 1960s and 70s were widely considered “buy and hold.”  Many investors ignored valuation.  They crashed in the early 70s, and were dead money for nearly a decade.  Similarly, after the dot-com bust, banks, energy, and emerging markets were leadership.  After the Great Financial Crisis, banks, energy and emerging markets were dead money for more than a decade.  We are entering a new regime, which will be defined by higher structural inflation, higher nominal growth, higher geopolitical risk, and higher rates.  This will not favor the previous leadership group.  This will favor small caps, energy, healthcare, materials, and industrials.  For the near-term, as inflation cools, the consumer behind a strong job market and over a trillion dollars in savings will support growth.  An additional support for growth will come from a 20% increase in corporate cap ex.  Fourth quarter growth estimates are firming up.  Market internals signal a similar dynamic, with leading indicators such as transports and semis up 16% and 19% since the start of October, respectively.  This will continue to support old economy sectors. 



One of the biggest investment consequences for this new regime will be a golden age for active management and a more difficult time for passive / index investors.  For S&P index investors you are making a big bet on the previous regime.  Your underlying exposure is highly dependent on large cap technology.  Large cap technology is approximately 22.5% of your exposure.  Overall technology, consumer discretionary (dominated by Tesla and Amazon), communication services (dominated by Alphabet and Meta) totals 44% of your exposure.  Throw in groups such as consumer staples and utilities which have limited growth potential, your total exposure is 54%.  These areas trade above a market multiple and are unlikely to benefit from multiple expansion as they did over the past decade, especially with higher rates.  Apple is currently valued at 25% greater than the entire energy sector in the S&P.  Mean reversion seems likely.    

Long-term bonds have a similar outlook.  The Fed has made it clear they will be higher for longer.  Bonds are losing many natural buyers.  The Fed is not buying anymore and many sovereigns are now net sellers of bonds, at a time when the deficit is very high and issuance will continue to be high.  This is a huge void that will be very difficult to fill.  Ironically, many buying bonds as a hedge for slowing economic growth might be disappointed as yields might rise due to the expectation of lower tax revenue driving increased supply.  Bonds could be in a situation where you lose in both expansionary and contractionary periods.       

Unfortunately for passive investors the areas where you want to be are just very small in traditional passive portfolios.  Take the clean energy transition.  If you count Tesla, there are just three clean energy pure plays in the S&P.  The S&P is well represented by large cap pharma but there is limited exposure to biotech and healthcare innovation.  The revenge of the old economy sectors, energy, materials and industrials are just 16% of the S&P.  Most of these areas trade cheaper than technology with higher growth rates.  Single stock correlation has been very high in the 85th percentile.  As the correlation eases, this will favor a stock and sector picking environment providing a tailwind for active management.  Commodities look to be an important allocation in this new regime.  Oil, gold, and copper are likely to serve as important hedges, especially for geopolitical risk.  As money gets tighter, risk management in position sizing and factor exposure will be more important, providing a source of alpha for active management.  A confluence of events is coming together to provide a golden era for active management.     


Looking forward, the market will continue to focus on the Fed, economic data, and geopolitics.           

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