What do GameStop, Tesla, SPACs1, and Bitcoin all have in common? They are all manifestations of a market bubble, which is a period in which speculators, who think they are “investors,” take what had started as a sound idea and drive the price upward to an absurd conclusion. One year after the onset of the pandemic, we find ourselves suffering from a fever in the financial markets.
As recently as late 2019, we were wondering whether the remarkable stock market rally of that year (remember it?) would lead to a disconnect between the financial markets and the real economy. Our phrase for 2020 was, “A good year for Main Street, but not so good for Wall Street?” For a variety of reasons, all spelled C-O-V-I-D, that issue was not one that mattered in 2020, but it may just be coming back into the picture for 2021. Many investors equate strong growth in gross domestic product (GDP) as essentially the same as strong gains for the S&P 500® Index.2 The effectiveness (and safety profile) of the approved COVID vaccines to date is giving more and more people hope for a full reopening of the global economy and a return to a semblance of normal—or at least whatever the new version looks like. The passage of the stimulus bill by the new administration is giving people, businesses, and state and local government the wherewithal to make that vision happen. With interest rates so low, bonds are no competition for stocks. What, say the bulls, could go wrong?
A Wall of Worry? Possibly about the Wrong Thing?
If only to demonstrate that stocks need a “wall of worry” to climb, many strategists are now of the mindset that an ancient nemesis that has been bottled up for the last 30-plus years, inflation, is going to escape its bottle, largely because conditions are ripe for price and wage increases to be announced … and stick. Consider this quote from the Wall Street Journal3 late in the first quarter, as typical of the concern and fears about inflation playing out:
“There are eerie parallels today. In 1973, the U.S. was coming off a two-year experiment in wage and price controls, which artificially depressed prices and muted signals that the economy was overheating. Then, too, the Fed pursued an easy-money policy, keeping interest rates low—though considerably higher than now, and without today’s purchases of bonds and mortgage securities …
In 2021, we are emerging from the pandemic shutdown, which cratered growth and slammed the economy—depressing price pressures, not unlike what the price-control program did 50 years ago. Today’s Fed policies are even more expansive. And Congress has just enacted a $1.9 trillion stimulus bill—on top of earlier relief bills costing another nearly $2.0 trillion, a lot of which remains unspent and will continue to fuel demand this year and beyond.”
As we have remarked in past Thoughts on the Current Environment, we believe the Federal Reserve (Fed) and the other central banks of the world have been playing a very dangerous game for the past 10 years, whistling past the graveyard, as it were, that inflation is not a problem. Inflation is a force that the Fed cannot control anywhere nearly as precisely as they may think they can, and it verges on arrogance to think that they can.
Curiously, they are also arrogant in an entirely different way, one they may not appreciate. Many Fed officials profess great consternation that simply pumping up the money supply at a rate faster than what the “real” economy truly needs should produce inflation. That is what all their models tell them. On the other hand, for 30 years, the Bank of Japan (BOJ) and the Ministry of Finance in Japan have made every conceivable effort to drive the rate of inflation in Japan up, and they have been just as consistently unsuccessful, all the while demonstrating a theory loosely attributed to Einstein: “Insanity is doing the same thing over and over and expecting different results.”
What the central bankers, on the one hand, and the inflation alarmists, on the other, may have missed all along is that we have had inflation, but it has appeared in a very different form than the textbooks write about. Inflation since the Great Financial Crisis ended in 2009 has been in asset prices rather than in the price of goods and services. This unique form of inflation is called a Bull Market. Milton Friedman’s view about inflation was right: “Inflation is always and everywhere a monetary phenomenon." What Dr. Friedman may have missed is this corollary: precisely how that inflation will express itself is a product of human emotions and cannot be modeled or forecast.
If so, then the inflation of the last decade has expressed itself as a rampant bull market, and the examples cited at the beginning of this essay are examples of the bull market moving into the speculative phase. The amount of money raised in tech private equity has driven the purchase multiple to absurd levels. During a pandemic, residential real estate valuations have soared! Asset prices have disconnected from any level of plausible valuation and are looking to be the 21st century version of the Tulip mania in Holland of the 17th century.4 All the examples referenced in the opening of this essay have qualified for the “What Were They Thinking?” Awards of 2023.
Preparing for the Next Phase
As a means to offer hope, there are many reasons—more than we can fit into one quarterly newsletter—to argue that inflation will not take hold. The purpose of this essay is to point out that the market thinks that inflation will present itself and we need to think about how we should be positioned from both from a tactical and strategic perspective. From a tactical standpoint, we believe the bond markets will remain at risk. Higher inflation will reach levels to which last year’s rates seem a distant memory. Short term bonds will fare better than longer term, but no bond with a maturity of longer than a year is going to escape the risk of price declines that more than offset the coupon, in our view.
Next on the list are high multiple, high expected growth equities, many of which were market favorites in 2020. That sort of stock, especially one not paying a dividend, is like a very, very long-term bond, and as such, will be hit hard as rates go higher.5 For the broader market, if strong real growth does not materialize, then we get the worst of both worlds, stagflation, with no real growth but just higher prices. Companies will respond to higher raw material costs and higher wage inputs as they have learned to in the last 20 years; relentlessly trying to cut costs. Automation will advance more rapidly to replace human capital. It will happen at customer-facing jobs (think fast food), in the office, and on the factory or warehouse floor. These responses will likely lead to higher priced goods and fewer employment gains.
When the Bubble Bursts
At some point, bubbles burst. The trigger may seem insignificant at the time, but in hindsight, it all seems quite clear. Sooner or later, people begin to realize that whatever was driving the bubble cannot be maintained indefinitely. For example, the ability of the government to continue to force feed the economy with liquidity on top of stimulus will come into question. The recently passed bill amounts to 9% of the entire GDP of the country. If interest rates do start to rise, it could leave the government with a bigger hole in its budget as it has to pay higher interest charges as it rolls over the massive amounts of debt at higher interest rates. Whatever the rationale, doubts will arise and spread, and as the market’s mindset changes, what seemed like a “good price” yesterday will prove to be anything but that tomorrow.
From the strategic perspective, this is not a call to sell. While many of the stocks that have been the focus of so much investor attention will be dragged out of the arena feet first, two-by-two, it is very important to keep this in mind: The stock market can go down a lot but that does not mean every stock will. It is a market of stocks, not a stock market. It is not crucial to figure out when to sell. That is an exercise in market timing at which no one has demonstrated repeatable skill. Instead, knowing what you own and why you own it—or, better still, having experienced portfolio managers backed by strong, experienced research teams doing that for you— is the way to navigate these volatile waters we may be entering. It is also going to be the very first “true” test for passive investing since passive is the very definition of owning ALL the stocks in the index. Saving a few basis points in active management fees is going to pale in comparison to the “cost” of owning every stock without discretion.
For some time, we have been making the assertion that administered interest rates, held low by the central banks for policy reasons rather than allowing market forces to play out, have distorted the playing field for investors. The two charts below are an example of this. We show by decade what the composition of return between income (dividends or interest) and appreciation has been for both bonds and stocks. The proportion of investment return for both stocks and bonds from income has averaged 39% and 73%, respectively. At year-end 2020, those ratios were 9% and 17%. Consider the trustees of a pension fund. They pay retirement benefits from investment income, sourced from both cash income and from appreciation. Over the last 90 years, cash income (a more secure and stable source of funding) has provided slightly more than half of a typical fund’s requirements. Using the 2020 figures noted above, that ratio is currently around 15%, meaning they are 85% dependent on price appreciation to remain adequately funded. This is just one more example of the hazards created by what the central banks have done.
1 A special purpose acquisition company (SPAC) is a shell corporation listed on a stock exchange with the purpose of acquiring a private company and then making it public without going through the traditional initial public offering process.
2 The S&P 500 Index is a broad measure of the U.S. stock market.
3 Wall Street Journal, “The Coming Demand Surge Brings Back Memories of 1970s Inflation,” William N. Walker, March 24, 2021.
4 According to” Extraordinary Popular Delusions and the Madness of Crowds,” Mackay, Chas., 18th Edition,1970, the mania began in England around 1600 and culminated in a great crash in Amsterdam and London in 1636, pgs 89-97.
5 Prices of existing bonds move inversely to changes in interest rates. As rates rise, bond prices will fall, and vice versa. High growth stocks, especially those that pay no dividends, can behave more like bonds in their sensitivity to changes in interest rates than a moderate growth stock which pays a dividend.
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