Stabilization, Inflation, and the Coming Rotation

Never in the history of the internet has the word ‘unprecedented’ been Googled more than in 2020. It makes sense as 2020 is truly a ‘unique’ year as the global economy has suffered dramatically due to COVID-19 related shutdown measures. While this did take its toll on the stock market in the first quarter, the largestindices are back in green territory as the overview below displays.- 

Tech – QQQ: +32.6%- S&P 500 – SPY: +5.5%- Dow Jones – DIA: -2.0%- Russell 2000 – IWM: -6.7%- Russell 2000 Value – IWN: -19.1%

While it is not that unusual that tech stocks tend to outperform small caps or the S&P 500, we are witnessing something truly remarkable. The difference between tech stocks and small-cap value stocks has reached more than 50 points since the start of the year. As figure 1 shows, the largest NASDAQ companieshave almost all significantly outperformed the tech ETF QQQ.Again, while it does make sense that some of these holdings do very well in a bull market, we have entered a situation of pure madness. Tesla, for example, has reached a market value in excess of $370 billion, adding more than 390% since the start of the year – meaning it’s now roughly twice as much worth as Toyota (TM). 

What accounts for such? Well, the Federal Reserve has beenmanipulating the stock market through market heavyweights like Blackrock and Citadel, who artificially push up a number of tech stocks in order to benefit Democratic Party members/donors and themselves. The stocks used for this purpose are displayed in figure 2. In this instance, the overview shows the holdings of the Swiss National Bank (“SNB”), which represents its foreign exchange reserves that have grown due to the need to intervene and mitigate the strength of the Swiss Franc. The SNB had kept its reserves and thus its portfolio reasonably unchanged last year, since March of this year, the size of its portfolio holdings skyrocketed. In particular, Tesla purchases were up almost 40% while only Apple was ‘lagging’ at slightly more than 10% in the second quarter. Interestingly enough, Blackrock’s Vice Chairman is Philipp Hildebrand, whoserved as Chairman of the Governing Board of the SNB, which implies that there is a larger network of participants involved in this ‘process’. While it is hard to say how long this manipulation will continue, there will be a limited window for such, as the public is noticing very weak market breadth, given that the aforementioned nine stocks have a weighting of roughly 55% in the QQQ ETF. As a result, we are witnessing a number of unusual developments. While commodities are breaking out, Russell 2000 stocks are lagging the S&P 500 (figure 3). Additionally, the same figure shows that 10-year government bonds yields are stuck below 0.70%, which is somewhat contrary to what the market would expect, even with QE. 

With this in mind, the question arises which stocks will be the biggest winners of the next rotation. This rotation is likely happening a few weeks before the election in the case whereby a Trump re-election seems inevitable, or immediately after the re-election. Unlike in 2016, we are currently seeing a completely different picture. For example, the VanEck Coal ETF (KOL), often considered the ultimate ‘Trump trade’, rallied more than 150% between the 2016 lows and the election on November 8, 2016. Meanwhile, the Russell 2000 outperformed the S&P 500 by more than 7 points during the same period. In 2020, we are seeing a severe underperformance of value and small-cap stocks. Bond yields, cyclical stocks, value stocks, etc., all seem to be suppressed while commodity prices continue to accelerate. 

Another example is the difference between the period between the 1987 stock market crash and the two years that followed. Back then, the Federal Reserve directed Goldman Sachs, Salomon Brothers, Warren Buffett, and others to buy equities. Steven Mnuchin’s father, Robert Mnuchin, was head of Goldman Sachs’ equity division until his retirement in 1990. As figure 4 highlights, based on the Russell 2000, S&P 500, and NASDAQ Composite, it is hard to see this past rotation. While small-cap stocks outperformed in the first four months after the October 1987 sell-off, they followed the other indices until October of 1989 when S&P 500 stocks started to break away and outperform small-cap and tech stocks. Unfortunately, although it is nearly impossible to find the motives Robert Mnuchin might have had when it comes to picking stocks for a rotation, the core holdings of Warren Buffettdo give us a clue. In 1988, Berkshire Hathaway’s largest holdings (>$100m marketcap) were Capital Cities/ABC Inc., The Coca-Cola Company, Federal Home Loan Mortgage Corp., GEICO Corp, and The Washington Post Company. As Cola-Cola is the only company that still exists as an independent listed company, I looked at some proxies representing media, (mortgage) banking, insurance, and compared these to the S&P 500 (figure 5). Insurer American International Group and mortgage giant Wells Fargo outperformed the S&P 500 by almost 40 points. Coca-Cola returned more than 117% while Disney and Bank of America rose by more than 160%. While this methodology is far from scientific, it seems to make sense – why would anyone push stocks without having exposure in a certain industry? 

Fast forward to 2020, and based on this premise, Berkshire Hathaway has reduced its exposure in financials significantly. The company cut its Wells Fargo exposure by 26.5%, sold 61.2% of its JP Morgan shares, 9.3% of its Bank of NY Mellon shares, 40% of its PNC Financial holdings, 15.7% of its M&T Bank shares, and its entire stake in Goldman Sachs. Meanwhile, the ratio of financials (XLF)/S&P 500 fell below 2009 lows. We are more than likely witnessing a situation where bigger players are pressuring financial stocks while rates are poised to move higher – backed by higher inflation expectations/commodities. 

Another important factor worth including is expected capital spending. As figure 6 shows, future capital expenditures accelerated after the 2016 election. Banks (KBE) did the same. They bottomed in the first quarter but then had a massive melt-up after the election, returning 30% in less than 30 trading days. The same happened to a lot of Capex related companies like Caterpillar (CAT), Deere & Company (DE), or Terex (TEX).


2020 is not only an election year but also the first year in history witnessing economic shutdowns caused by a virus. The first quarter, which saw a steep and severe sell-off was followed by an almost unprecedented rally in tech stocks. In this case, the QQQ ETF is up more than 30% since the start of the year. However, this move was supported by market manipulation by the Fed/Treasury, benefiting nine large tech stocks, whose rally dwarf that of the broader QQQ. This seems to have caused at least one case of potential insider trading as the SNB has significantly increased its stake in these nine companies. 

While it is hard to say when the next rotation will take place, it can be assumed that the next election on November 3 will function as a trigger. Just like the 1987 crash, 2016 was different from 2020 in many ways. Nonetheless, we are seeing similarities with regard to economic strength. In both years economic growth was weak with lower Capex due to uncertainty. The election of 2016 was followed by a boost in Capex and soaring stock prices from banks and Capex-related stocks. Such a situation is likely developing as the Fed framework is changing while Trump’s odds to get re-elected are turning in his favor.

As Warren Buffett reduced not only his Wells Fargo exposure but also lowered his exposure in well-run banks like Goldman Sachs and JP Morgan, it can be assumed that financials are on a lot of buy lists going into the fourth quarter based on the assumption that the past few months were used to get investors and traders out of financials. The current development in technology stocks is not sustainable as inflation expectations are rising because of higher commodities, a lower dollar and bottoming economic growth. Government bond yields are at unsustainable levels and should soon make a move higher. 

Regardless of the underwhelming performance of small-cap stocks, financials, machinery stocks, etc., it makes sense to own exactly these stocks going into the fourth quarter and beyond. Rising inflation, backed by bottoming economic growth, will stimulate Capital orders, the need for financing, and benefit banks as bond yields are likely to rise – making banks the likely winners of the next rotation.