Over the course of the last few weeks, investors have been slowly wandering away from their pandemic picks to engage in the opposite bet; the reflation trade. And while the whole world of investors briefly paused on the trade to take a run up (and down) GameStop (GME) Mountain alongside Redditors, the rotation has since picked up the pace as markets lost interest in the luster of diamond hands.
When the pandemic hit and stay-at-home orders were given, the most likely outcome resulted: the majority of businesses, especially smaller ones that require a physical presence, struggled as they were cut-off from vital demand. This led investors to bet on a select few stocks, primarily tech and communication services companies, due to their vital role in helping the world transition to a work-from-home reality. This drove the prices of these stocks to record highs, while the rest of the market crashed and slowly crawled higher, gaining a boost here and there with economic stimulus and other policies to bolster consumer spending.
Now, with further economic stimulus likely on the way and the vaccine starting to impact Covid hospitalization, death and transmission rates, these stocks are emerging out of the woodwork and entrancing investors with their newfound attractive valuations in a classic "Ugly Duckling" transformation.
As we know from the many Ugly Duckling-themed movies, the glasses-off, hair-down jaw-drop scenes are turning points, but they are far from the beginning and end of the story. There’s usually a friendship that develops, then a makeover, and then the glasses come off.
And it’s no different with stocks. For Industrials, Financials, and Travel and Leisure companies to do their best "Laney Boggs" after the past twelve months, it took a full-on economic policy makeover for the conditions to be met for the big transformation.
Reflation is the first phase of economic growth and typically marks a turning point for a recovering economy. Reflation is what happens when there is both a bump to prices and wages. As companies open up and begin hiring, they must out do their competitors for the best employees, thus forcing them to raise wages. This in turn results in higher-priced commodities as companies are forced to charge more for their goods and services, leading the economy into the next phase: inflation. As this happens, yields on Treasury bills increase, spurring bond holders to trade their older, lower yielding bonds for new, higher yielding bonds. This swap of bonds is known as a reflation trade.
During these inflationary periods, stocks tend to do well on account of a growing economy. The biggest winners during these times are those that are tied to commodities as well as banks, and under-priced value stocks. This is because the banks make the loans to help increase commodity production, allowing the companies that are traditional value stocks to produce more goods to sell to the now higher-paid employees.
Glasses Off, Hair Down
With that in mind, the best way to find your Ugly Ducklings is to look for stocks that are low priced relative to where they were before the market crashed. These stocks will likely return to their valuations as the economy recovers, barring bad news, earnings, and technological advances that render their goods useless, that is.
In the case of the pandemic, you can probably think of these companies by simply thinking about what you’ve missed the most by not being able to go out freely. What restaurants did I miss that most, where am I vacationing as soon as this is over, how will I get there, and other questions like that will help you think of companies that may be prone for a rally as things open back up. American Airlines (AAL), Carnival Corporation (CCL), and Chevron Corporation (CVX) are all examples of stocks that should experience much higher demand as the economy reopens.
Another way that people can do this is by taking a more holistic approach to identifying reflation trades by investing in the ugly industries through ETFs, rather than committing to any individual one. This could be done by investing in the likes of the iShares Russell 2000 ETF (IWM), the Fidelity MSCI Industrials Index ETF (FIDU), the Dow Jones US Regional Banks Index (IAT), and the iShares Dow Jones US Consumer Services Sector ETF (IYC).