Thread by @BvddyCorleone

Why Inflation Will Kill the Ponzi Sector (and Catalyze the Long-Awaited Sector Rotation from Growth to Value)...

A thread.

This topic was a black box to me a few weeks ago. I will try to crystallize what (I think) I now understand.

Disclaimer: Nothing in this thread is original. It brings together pieces from random tweets and discussions I’ve had recently, most notably with @hkuppy, @pineconemacro, @greekfire23, and @contrarian8888.

1- Inflation causes long term rates to rise. This is illustrated by the Fisher equation, which states that the risk-free long term bond yield (i) equals the real rate (r) plus inflation expectations (π), i = r + π.

1A- It also makes sense intuitively: inflation causes long term rates to rise because lenders require compensation for the loss in purchasing power of the money they lend out that will occur over the duration of the loan.

2- Growth stocks have become long duration assets, so when long term rates (the discount mechanism for valuation) rise, growth stocks get smacked. Since a larger bulk of their PV comes from expected growth in future cash flows, growth stocks are more sensitive to a rise in rates.

2A- Put bluntly, the Ponzi math used to arrive at current colossal valuations for growth stocks simply doesn’t work when you’re discounting back at, say, 5% instead of less than 1%.

2B- Conversely, value stocks are short duration assets with low price to book and are thus less impacted when rates rise. Old economy assets with lots of sunk capital & low incremental costs will get some love since any increase in prices will mostly serve to increase their ROA.

3- Now for some charts...

We can already see that QQQ/IWN has become tightly correlated with long term bonds $TLT:

4- And let’s not forget the blow-off top in $QQQ/$IWN on the 20y chart, which has taken some time to form:

4A- Let’s zoom in and look at the last 12 months of that same chart. The break of this trend-line might be key:

5- Also important, the growth/value spread has been whipsawing wildly. Notice the last two times we’ve seen this type of factor volatility, in 2000 & 2008:

6- We’re also currently witnessing the longest period of value underperformance relative to growth. And this decade’s performance is the worst in history for value stocks:

7- In sum, people have been calling for this rotation for years... Though it hasn’t happened yet, things can change very quickly. If the spread is pushed hard enough, it could snap a few thousand bps over a short time period and unwind violently, like it did in Q2’2000.

8- Buckle up. Listen to what the market is saying beneath the surface. Forewarned is forearmed. Let’s have some fun.

I missed a few others who - directly or indirectly via podcasts, tweets, articles, etc. - helped add clarity to my thinking on this subject. HT @profplum99, @trader_ferg, @ElonBachman, @Convertbond, @RaoulGMI, and others. Feedback always welcome and appreciated.