In the new paradigm, defense and energy are winners

However, it is important to keep track of what is actually the status quo, what this static average really is. Because if there is something that has led to big losses, it is when investors have mixed up the terms "cycle" and "trend". When the cycle is in an upward phase, economic activity increases, profit margins expand, both consumers and investors become more optimistic, more goods, real estate and shares are bought, partly financed with the profits, partly by increasing leverage. All these factors feed on each other in a procyclical pattern. Unless you zoom out to a helicopter perspective, it's easy for beginners to believe that the last 10-15 years crepresent a long-term trend rather than of just another half-cycle.

"These are the new times" is often said when it becomes difficult to fit today's figures into the same chart as the historical series. But sometimes it is indeed new times. Like now. Approximately once a century there are new times. Old institutions disappear and new ones emerge, peace can turn into war, truths such as "cash is trash" can be inverted to "cash is king", perpetually rising markets and positively trending profit multiples are reinterpreted as insane peaks, high levels of debt go from being perceived as efficient to insane and mindless. Actually, there's nothing new about this either, it's just part of the cyclical nature of humanity. But since we only live for 100 years, it feels brand new every time.

Now, in the 2020s, a trend reversal seems to be underway. This is partly because, after 15 years of strong stimulus, we are approaching the peak of the cycle. Inflation and rising interest rates lead to a slowdown, with fewer units sold and less need for employees, in a self-reinforcing downward process. Lower activity makes it more difficult to service the same level of loans, and as loan losses increase along with fewer loans issued and raised, activity declines further. The stimulus intensified and accelerated economic activity with the help of debt financing, but now the bill must be paid with activity below the trend. The stock market experience of the downturn is doubly negative as it had become accustomed to growth in both profits and earnings multiples:

During the boom phase, growth companies are rewarded and 'truths' such as 'buy and hold' are proclaimed. "Don't sell your winners", it says, although in practice the meaning is often "keep the most expensive instead of exchanging it for more affordable alternatives". The Buy and Hold advice is really based on buying and holding until you find something better to buy and hold, but many people miss the second part of the advice. Buying technology stocks and holding them throughout the zero interest rate era of 2009-2021 worked great, but these are new times now. Not new new times but slightly more new old times as in the cycle or the pendulum manifesting itself in a decline.

What has happened is that various bottlenecks and suboptimal global economic organization have manifested themselves in inflation and war. After decades of high growth, China has begun to catch up with the previously undisputed world leader, the United States, and has encountered obstacles in its frenetic growth. At the same time, the US has finally hit the wall of inflation after at least as many decades of a debt-financed consumption boom. Both superpowers are feeling the pain and looking for different ways out. China has chosen to cheer on Russia's desperate attempt to unite the people as the propaganda about the threat from the US is no longer working on the increasingly enlightened young adults in Russia. Thus, just when inflation threatens the Western economic house of cards, China is taking the opportunity to create even greater price increases, with rearmament costs, food shortages and inefficient transportation routes for Russian oil and gas.

These are new times, as always a struggle for the world's resources, for money, power and glory, for the pride and support of the people. So it is as it has always been - after the rise comes fall. This time it's about zero interest rates and rising valuations in the West being replaced by inflation, a decline in the real economy, falling valuations and asset prices, and an increasingly angry population wondering why interest rates, rent and food became so expensive, while housing prices make it impossible to borrow more even if you want to, not to mention trying to sell the house. In the East, it's about the stagnation of perpetual growth and, even there, about dreams of housing-financed prosperity being shattered as we speak. In the choice between freedom and stability, China has now turned away from capitalist principles and some freedom, towards a hard command economy with, social scoring as an effective means of power.

After 30 years of favoring growth stocks where no valuation level is considered too high, we are entering an era where cash flow is now rewarded. An era where annual returns and dividends must be sufficient to finance the daily costs of food and interest in times of high inflation. It may turn out in ten years that paying 13 times earnings for Service Now or 25 times sales for Snowflake and Cloudflare (both of which are also loss-making) was the right thing to do, but it will not work in the interim period when you can buy what is needed now at immediately rational prices. The big oil companies, for example, are trading at just 8 times annual earnings, despite rising commodity prices and reduced available supply from Russia. And there are smaller companies, with greater elements of new extraction and of course higher risk, which are trading at half the giants multiples. Swedish Africa Oil is one such example. For approximately P/E 4, you get the existing operations, and as a real kicker, the quite likely potential is that the Venus field outside Namibia may bring double the profit level in a few years.

There is a strange valuation discrepancy between so called high tech in the form of server farms with administrative systems, i.e. "the cloud", and on the other hand, genuine real assets such as raw materials and defense companies. The loss-making companies with their heads in the clouds are valued at 10-30 times turnover despite the fact that they are all just some kind of accounting program without much innovation value (although I understand the potential for strong cash flow for the winners). And the oil companies, which are supposed to drive the entire economy, are valued at 5-10 times the profit, despite a likely shortage of the raw material and thus sharply rising prices as soon as the economy picks up again. But, note that the valuation is low even before this happens. 

This weekend's OPEC production cut also shows that Saudi Arabia is prepared to keep prices high rather than volumes. With only a 5% reduction in volume, an immediate price increase of 6% was achieved, which thus gives increasing profit to the entire operation. There may therefore be more of the same kind in the future.

This is where I wanted to go all along with this article on the new world order. China and Russia want to force the US into preparedness and an eternal expensive war. It impoverishes the US and fuels inflation, and gives China motivation for tougher rule at home to maintain control and stability even though it can no longer keep the promise of prosperity to its people. As inflation bites into the world's wallets and bullets fly, all countries close ranks. Just in time production becomes just in case, with home production and larger stock. Everything becomes more expensive and less efficient: transportation routes, manufacturing costs, warehousing, etc. The beneficiaries are necessary real assets, i.e. raw materials and defense. Also don't forget that the defense uses a lot of energy, i.e. oil, plus almost all modern military equipment is manufactured with scarce metals such as copper, silver, earth metals, cobalt, nickel, etc.

Defense companies are not very cheap; the big American ones are traded at approximately the same multiples as the stock market, but on the other hand they are likely to grow much faster than the average company in the next decade. Northrop is valued at 15 times earnings, General Dynamics at 19x and Lockheed at 22x. Swedish SAAB really stands out with a earnings multiple of 37 after the recent price tripping, so I would hold off on that one despite the much higher expected growth rate. The same thing as for SAAB applies to American Howmet Aerospace, but both are worth setting coursers on to take advantage of temporary setbacks.

Almost all of today's investors are used to low interest rates, low inflation, peace, globalization, free software, rising housing prices, easy access to debt financing, rising stock prices, monetary and financial stimulus packages, etc. The stock market has also become accustomed to rising valuation multiples, especially for the technology sectors – even as many of the companies are losing money and others are facing regulatory scrutiny as they try to grow through acquisitions or exploit their de facto monopoly power. The key word is that we are moving from duration tolerance to intolerance. Now time and money and risk cost something again. It is just as impossible for a company to build global logistics chains on just-in-time principles as it is for private individuals and investors to live on future profit potential, loans or house prices.

The ESG trend is part of this. In good times, it was easier to invest in distant environmental technology, while oil was seen as obsolete as well as dirty. This has led to underinvestment in the sector, which will manifest itself in shortages and price spikes in the next upswing. To oil, electrification minerals and defence, one can probably also add parts of the fertilizer and food sectors, and with some distinction, some banks. All are examples of a kind of infrastructure, the real framework of the economy. All are also traded at very low earnings multiples – often for good reason, but also to a typically exaggerated extent due to the craze for technology companies. As the duration tolerance now turns up along with inflation and interest rates, sector rotations on the stock market can produce a large relative movement in valuation from the "P/S (Price-to-Sales) above 10" companies to the "P/E below 10" companies.