We get many questions about the best “Epicenter” stocks to buy. We recommend that our subscribers get diversified exposure to the Epicenter trade by using the Invesco S&P 500 High Beta ETF (SPHB). The fund contains a significant amount of our ‘Epicenter Trifecta’ stock picks. The selection criteria are pretty simple for this ETF; it selects the 100 stocks with the highest beta over the previous 12 month period out of the S&P 500. So, even though this is a specific way to get access to “Epicenter” stocks, the diversification it provides is also appealing. The nature of beta and correlations was significantly changed by the advent of the first pandemic in the era of globalization. About 7% of the entire US economy is what we could call ‘social distancing casualties.’ While these stocks were expected to go to zero potentially, they have instead proven their survivability and dramatically cut costs to maintain solvency. They will thus have higher EPS potential than consensus expects.

SPHB: Getting To Alpha By Way Of Beta

Source: SeekingAlpha

A one month Total Return Chart of the SPHB, SPLV, and S&P 500 illustrates quite nicely the current dynamic with beta in the market. When there is turmoil or uncertainty related to COVID (or Reddit in late January’s case), capital flees high-beta for assets less susceptible to the harsh downside moves of a market fixated on when economic normalization can begin. As volatility increased, it significantly underperformed; as it decreased, it begins to outperform again.

The stock market is now highly correlated to healthcare outcomes. As far as exogenous threats to the stock markets go, the suspension and depression of economic activity associated with a global pandemic are about as severe as it gets; particularly for the Value/Cyclical names that make up the “Epicenter” cadre of stocks. However, because the downside is very nasty when adverse healthcare developments occur, they also should expose investors to great risk-adjusted returns when the virus is finally vanquished. We have several reasons to believe the ‘Epicenter’ stocks will outperform based on historical data.

Firstly, their margins are near the lows achieved during the financial crisis and will snap back similarly. Secondly, when real interest rates are historically this low, the ‘Epicenter’ sectors tend to outperform. Thirdly these stocks are hedged against inflation risk. Finally, anomalous VIX behavior in 2020 suggests that volatility will collapse in the following years, beginning in 2021. When this happens, the ‘Epicenter’ aka. Value/Cyclicals tend to outperform dramatically.

2020 Was About Symmetry, 2021 Will Be About Cycle Reversion

SPHB: Getting To Alpha By Way Of Beta

Source: Fundstrat, Bloomberg, Factset

At the beginning of the crisis, we noted that even if all these businesses failed due to the tragic events that 93% of the US economy would remain unscathed. Well, these companies didn’t die. They survived the unthinkable. Thus, their equity valuations should particularly appreciate when the pent-up demand and celebratory environment coalesce in what we believe will be the biggest boom-cycle of the 21st century so far. We also think that the ultra-cyclical nature of this comeback will immensely benefit the Value/Cyclical stocks that primarily make up the class of stocks we refer to as “Epicenter.” Just as the symmetry and prices were predicted by historical data, we believe that ‘Epicenter’ stocks will have an even more remarkable margin comeback. There are many reasons to believe their recovery would exceed that of 2008; a recessionary environment not marked by the dramatic interruptions in demand we see adversely affecting specific industries.

SPHB: Getting To Alpha By Way Of Beta

Source: Fundstrat, Bloomberg, Factset

Our Head of Research, Tom Lee, coined the term “Epicenter” stocks. This category is essentially comprised of those equities that were closest to the economic and social consequences of COVID-19. Perhaps it is easy to forget how precarious many investors thought the future was for these names. Some may be wondering if they’ve had a high enough run; we believe that the outperformance of high-beta stocks (in a post-COVID-19 market) has only just begun. Why do we say this? For the same reason, our Head of Research, Tom Lee, made his great call in March 2020, because we rigorously and religiously analyze data to try to listen to what the sum of the available information tells us.

SPHB: Getting To Alpha By Way Of Beta

Source: Fundstrat, Factset

This data seems to tell us that the margins of ‘Epicenter’ sectors have likely bottomed and will begin reverting to more normal levels fueled both by cyclical forces and the do-or-die cuts that were necessary for these companies to survive.

“Easy Money” Real Interest Rates At Multi-Decade Lows

Historically the 10Y is above the nominal rate of GDP growth. However, that is not currently the case. We anticipate the real interest rate will be around -6% from 2020-2023. This is very easy money and is supportive of asset prices. Similarly, we think that US households are synthetically short equities since the vast majority of their allocations have been into bonds. As the alpha generated by these high-beta names becomes undeniable in the face of economic re-opening, we expect many investors will chase the outsized returns and drive prices even higher. We think the low-real interest rate environment is supportive of our thesis.

SPHB: Getting To Alpha By Way Of Beta

Source: Fundstrat, Bloomberg, Factset

Asset Heavy Companies Serve as Good Inflation Hedge

Many investors have had to ‘dust-off’ inflation playbooks because it hasn’t been a severe threat to returns in decades. We think that many ‘Epicenter’ companies are asset-heavy, meaning the value of these assets will go up in a reflationary environment. Think about proven oil reserves on an energy balance sheet or a loan-book value during an expansionary cycle. These assets’ value will increase. Coincidentally, Energy and Financials, two of the hardest-hit sectors, are the primary sector components of the S&P High Beta ETF (SPHB).

SPHB: Getting To Alpha By Way Of Beta

Source: Fundstrat, Bloomberg

Normalization of Volatility Suggests Outperformance of SPHB Components

If you’re looking at the historical performance of SPHB, you’ll notice that its performance differs over various time periods. Over some periods, you would be better off owning the S&P 500 outright than owning the SPHB. We showed you the performance over the last month but now look at performance over other periods.

SPHB: Getting To Alpha By Way Of Beta
SPHB: Getting To Alpha By Way Of Beta
SPHB: Getting To Alpha By Way Of Beta

Source: SeekingAlpha

You can see in the analysis across multiple periods that essentially, since COVID-19, there has been much alpha in the SPHB. However, when you look at the 10-yr price-performance, you can see you were not compensated well for the risk you were taking over that period. Investors who have enjoyed significant returns and hold SPHB at an All-Time-High may be rightfully asking if there’s still room to run.

We think the answer, given the historical volatility data, is a resounding yes; there is still much room to run. The VIX was highly anomalous in 2020 and spent most of the year in backwardation across its term structure. This literally means, counter to the typical relationship that volatility has with time, that investors expected more volatility in the short-term than further out ahead. We use the 4M-1M VIX as a proxy for the type of market inversion that only occurs during periods of extreme stress. The anomalous VIX term structure’s duration suggests to us that a collapse in volatility is imminent. Historically, when volatility has collapsed, this means that you get compensated way better for the risk you are taking in high-beta names. In other words, to get to alpha during times of low volatility, which we anticipate will soon be upon us, go through beta.

SPHB: Getting To Alpha By Way Of Beta

Source: Fundstrat, Bloomberg

Risks and Where We Could Be Wrong

Obviously, the biggest threat to our thesis that high-beta stocks will outperform as volatility collapses is if volatility for any reason does not collapse. We see the biggest risk to our thesis materializing is clearly either interruption of the progress in mass-vaccination campaigns or the emergence of variants on a scale that can significantly reduce immunity and lead to new outbreaks. However, we monitor virus data quite closely and there appears to be a more negative sentiment than is reflected by the current organic breakdown in new cases, deaths and hospitalizations. Even so, COVID-19 is an incredibly mysterious disease and we remain humble and vigilant to the many future prospects that could result in volatility continuing to remain elevated.

Prior “Signals”

    
DateTopicSubject / TickerThe Signal
02/05/21StockExxon-Mobil (XOM)Why Exxon-Mobil Is A Buy Despite Mixed Earnings
01/28/21SectorEnergy GICS-1 (XLE)If You Like TSLA’s 2020 Performance, Try The Energy Sector
01/15/21StockFord (F) ‘Epicenter’ Stock With EV Upside and Great Management
11/05/20StockIngalls & SnyderDespite Gyrating Markets,  This Manager Returned 40% in ‘19
10/21/20Stock10-K Filings Part 3Other Voices: Why Reading 10-K Filings Is Crucial; Part 3
8/19/20Stock10-K Filings Part 2Other Voices: Why Reading 10-K Filings Is Crucial; Part 2
8/6/20StockTruist Financial (TFC)Never Heard of Truist? This Bank Stock Could Rise Up to 30%
7/29/20StockWeight Watchers (WW)Weight Watchers Can Continue to Outperform Post COVID-19
7/22/20StockXilinx (XLNX)If EPS Rises to Pre-Covid-19 Level, XLNX Could See Old Highs
7/15/20StockMarket ConcentrationNarrow Mkt Rally Fuels Worry; We Expect Cyclicals To Join
7/8/20StockSEC FilingsOther Voices: Why Reading 10-K Filings Is Crucial; Part 1
7/1/20StockSimply Good Foods (SMPL)Post-COVID-19, Simply Good Foods Stock Looks Appetizing
6/24/20StockLam Research, Applied MaterialsLam Research, Applied Materials Set to Reap IoT Harvest
6/17/20StockNordic Semiconductor (Nod.NO)Continued IoT Growth Good News for Nordic Semiconductor
6/10/20StockHelmerich & Payne (HP)Helmerich & Payne Stock Could Energize Your Portfolio
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