Nicholas Colas writes a widely-read morning note for money managers that draws on the New Yorker’s 30-year career on Wall Street, filled with insights gleaned from economic data, market dynamics, investor psychology, and disruptive trends.
Colas, co-founder of DataTrek Research, got his first glimpse of Wall Street from the mailroom of what is now Alliance Bernstein as the mutual fund industry was taking off in the mid-1980s. Colas began his official Wall Street career in 1991 as an equities analyst covering autos for Credit Suisse. He went on to work at SAC Capital, where he learned from hedge fund manager Steve Cohen the importance of understanding emotions in investing, and later worked at other firms as a market strategist and head of research before launching DataTrek in 2017. Colas has been bullish on Big Tech and the power of disruption for years, and began writing about Bitcoin in 2013.
Barron’s talked with Colas about why he still likes U.S. stocks despite inflation, high valuations, and the risks of Omicron. In this edited version of our conversation, we also find out why he says it’s crucial for investors to learn financial modeling and monitor cryptocurrency developments.
Barron’s: What’s the biggest shift caused by the pandemic that is most relevant to investors?
Nicholas Colas: Inflation. That has been the biggest change in the economy. Stuff costs more—and not a little, but a lot more, and over two years. Food is up 15%; wages are not. As an investor, we have to think about how inflation will ebb and flow and impact corporate profitability. For big companies, it’s good for profits.
Are worries about inflation’s impact on corporate earnings misplaced?
So few analysts know how to model a company anymore. I was trained by people who built their careers in the 1970s. It comes down to understanding how costs flow through an income statement. People think if PPI [the producer price index] is up 4% and inflation is up 4%, earnings don’t grow. That is absolutely wrong. Every company has a fixed cost structure that doesn’t move with inflation. We see this in the data: Corporate profits in the 1970s grew just as fast as inflation did—and the stock market grew just as fast as earnings.
The linchpin of this market is—and has been—corporate earnings. It’s totally reasonable to think about $240 for S&P 500 earnings next year; the Street is at $222. For perspective, we were at $162 to $163 in years prior to the pandemic. We have set a new step function in corporate earnings—and it seems permanent.
How can margins stay high, even as companies deal with rising labor costs, supply-chain issues, and regulatory pressures?
Pricing power. The S&P 500 is very different from any other index on the planet. It has two things going for it: Primarily it works in the U.S. economy, and U.S. fiscal and monetary policy was orders of magnitude more aggressive than Europe and Asia. So that was a huge bump, and allowed margins not to go to zero during the recession.
And we are talking about large U.S. companies, which have huge advantages in economies of scale and scope over smaller companies, and, because of the cash flows they generate from their U.S. operations, have much stronger competitive positioning overseas. The most important thing we have is big technology. It’s impossible to overstate how important it is to have 20% of the S&P 500 in [Alphabet’s] Google [ticker: GOOGL],
[MSFT]. There’s simply no way to line up those business models with anything else.
These companies have been winners for years. Can that really continue?
There’s human bias to momentum but also investment validity to sticking with momentum. I’m not talking about momentum [as a factor], but rather fundamentally things that are holding and increasing their competitive position. I don’t see a reversion to the mean for tech margins because these companies have competitive positions in ways we haven’t seen before, maybe besides Rockefeller’s oil company and Vanderbilt’s rail. Oil was relevant for 60 years, so when they say data is the new oil, it suggests data has a competitive window longer than traditional business models.
Should investors be buying dips in these stocks?
That’s a separate discussion about how much confidence investors have in the global economic recovery. Probably in the second quarter, you will have a burst of enthusiasm for a synchronized global recovery—and you could see Big Tech underperform for a couple of quarters because people will be enthusiastic about financials, industrials, and even energy. It’s not a matter of, “If Apple is down 5%, buy the dip,” but more that [their] corporate profits are super sticky, super stable, and they have very high-valuation earnings. You really want to own the biggest, best, and brightest, and the S&P 500 is that index for the world.
Foreign markets have lagged behind the U.S. for a couple years now. Should investors shift some money abroad?
It’s always tempting to think about reversion. However, do we seriously think an economy with zero population growth [like Japan] can truly have a sustainable rebound in valuation? Do we think a region with negative rates [such as Europe] can have a sustainable rebound? Is there anything novel in tech companies in those regions that will gain relevance versus the U.S., except maybe
[SAP]? The short answer is no.
What about China?
There will be a great trade in China, probably past the 20th Party Congress [in the fall]. But in the near term, there’s just too much uncertainty.
What are you monitoring most closely out of the China-related developments?
I care most about how China supports or suppresses technology innovation because that is the only thing that makes you a lot of money as an investor. If you want to beat the market, you need to identify inflection points in innovation.
The government [has been cracking down on technology companies] because there’s been such dramatic imbalances created by technology and the pandemic. That market is four times the size as here, and if that means some 30 rapacious technology companies chewing away at the social fabric, then [Beijing] is doing the right thing. But if this has a chilling effect on innovation, then the Chinese equity market is not going anywhere for a decade.
The pandemic has brought some major changes in behavior. What are you keeping tabs on that could impact investors?
We use Google Trends every day because it’s a fast window into consumer behavior. The No. 1 thing we worry about from the stock market’s perspective is how much consumers are paying attention to Covid as a proxy for the fear they feel in their lives. Americans have had three separate cycles. Omicron is getting some attention, but it’s not outsize yet. I ran Covid Google searches for the U.K. for this past Monday’s report, and those have spiked to new highs. So that’s a worry if we get the same sort of spread of the virus here.
How should investors be thinking about their bond allocations?
Bonds at this point in the cycle—and we’re talking mainly Treasuries—have one utility. It’s not income. It’s a hedge, allowing you to stay invested if we are wrong and something comes across that’s bad.
What is the risk you are most worried about over the coming year?
At points of inflection, like we are with inflation and the economy, there’s always the possibility of a Fed policy mistake. We use the
FedWatch Tool to see what probabilities are attached to Fed policy next year. When the market factors in four rate hikes next year, I will begin to get worried. Go back to 1994. That was the first rate cycle I saw, and the market rolled over so fast because the Fed moved in a total surprise by 50 basis points [0.5%] and then kept raising rates, causing a massive rotation. An inverted curve is the second phase of that warning sign of a recession ahead.
How important will total return be in the coming year?
Stock buybacks are more important than dividends because the market—at 21 times earnings for well past the bottom of the cycle—is saying corporate cash allocation is going to be ferociously efficient. Companies won’t waste money on dumb acquisitions, bad projects, or global growth that don’t make sense and are going to be hyperfocused on maximizing return on capital. Buybacks are the safest choice for a CFO to recommend the board do with incremental cash flow—and S&P 500 companies have more excess cash flow than ever before.
The energy transition is getting a lot of attention. What’s the takeaway for investors?
You have to pay attention because it’s technology innovation—and that’s what drives sustainable long-term returns. The trade—for a horizon of one year or less—is traditional carbon-based energy because global demand will continue to increase and it can’t be substituted away. Already, we are close to 2019 levels with 40% office occupancy.
What’s the investment?
Valuations don’t make a lot of sense [for existing alternative-energy companies], not because the market is being stupid but because there’s not enough of them. When there’s a new hot trend, a handful get a valuation premium. Venture capital figures it out and funds better companies. They go public, and valuations get better and normalize. As new ones go public, you need to look at every single one because there will be a lot of winning companies in alternative energy—but not all public are yet.
Investing with an eye to environmental, social, and governance factors, or ESG, is also a big trend. Is this sustainable?
ESG will only grow in importance over the next decade. Growth will be something between arithmetic and logarithmic. People want to invest this way, and feel like their money is doing more than just making money for them. That’s a huge change in my 30-year career; I started in the greed-is-good Wall Street of the 1980s that viewed capital allocation as the end goal.
There’s confusion over what is ESG. How does that get sorted out?
ESG, as it is expressed now, has to be quantifiable and rules-based. The discussion is going to be how much disclosure is accurate and valid—and what the models do with it. There’s going to be as much attention to ESG accounting now as there was on accounting in the 1970s and 1990s. We are in the early stages of forcing the accounting discipline into the ESG priority set.
What areas or issues aren’t getting enough attention?
The world of venture capital, virtual currencies, and decentralized finance. We talk about disruption in every report. It is why U.S. equities have done better than the rest of the world. It’s because of VC funding in 1999 and 2000 that we have
com, why Apple is still alive, and why the S&P 500 has 16% 10-year compounded annual growth rate—double the rest of the world.
What’s the outlook for crypto?
It’s still a couple years away. How the Fed develops its thinking will matter. The risk is you get a USD coin that becomes a de facto Fed coin because [stablecoin] isn’t a heavily regulated market. I have to push back on clients who say crypto is a fad. No, it’s not. Plus, even if you hate the idea—and it is a fad—the cassette tape brought down the Iranian monarchy! It had huge impacts on global geopolitics; you can’t ignore [crypto]. The big story in crypto this year will be that the assets themselves don’t do much, but we’ll start to see mainstream use cases in payments and decentralized finance.
Write to Reshma Kapadia at [email protected]