2021 1st Quarter Market Commentary

The securities markets experienced drama in positive and negative directions in the year’s first quarter, as the Federal Reserve and most other world central banks continued to flood their respective economies with newly printed money. Only risk-free securities avoided the excitement. In fact, Three-Month Treasury Bills barely registered a pulse with a 0.01% return. By contrast, Barclays Long-Term Treasury Bonds recorded their worst quarter in 41 years at       -13.51%. In concert with investors’ eagerness to adopt risk, CCC-rated bonds, the junkiest of junk debt, closed with a gain of 3.47%.

Gold dropped by -10.4% in the quarter but closed up by 7.9% for the 12 months ending March 31. We reduced our multi-year gold hedge at higher prices a few months ago and added back part of that position at the very end of the quarter, at about 5% below its current mid-April price.

Riding the incoming tide of new money, only equities provided any appreciable return in the quarter. Interestingly, the giant growth stocks that have powered the rally from the pandemic lows lost their leadership role in the first quarter. Long-ignored value stocks pushed the S&P 500 up by 6.17%.

The market narrative remains largely the same as we enter the second quarter. Because of government cash distribution —even to people who didn’t need it —incomes grew more during the pandemic than they normally do in a typical economic expansion. The Fed has pledged ongoing monetary support even if inflation rises above its 2% target. Vaccines are increasingly available, resulting in large portions of the economy reopening. With the economy and corporate earnings expected to grow strongly through 2021, a large volume of retail and institutional money has flowed into equities in anticipation of further price gains.

But the environment is hardly risk-free. Despite massive governmental monetary and fiscal stimulus, employment and most economic measures are still below pre-pandemic levels. Notwithstanding significant mitigating progress, the virus and variants still rage in parts of this country and around the world. Higher taxes are on the horizon to pay for proposed fiscal benefits. Interest rates have risen substantially, and inflation has begun to rise. The U.S. has imposed new sanctions on Russia, and Secretary of State Blinken has warned about China’s aggressive behavior toward Taiwan. From a purely investment perspective, by many measures stocks are more overvalued than ever before. At the end of the quarter, the median price/earnings ratio for the S&P 500 hit a new record high, three standard deviations above the median level of the past 57 years. It’s a fair question to ask: What is the justification for the highest level of valuation ever if the Fed Chair is so fearful of potential economic weakness that the Fed must continue massive monetary creation?

Valuation is hardly the lone area of extreme speculation. Crypto currencies have grown dramatically in popularity over the past few years. Bitcoin has gained the greatest following with its price soaring in recent years from virtually nothing to over $65,000 last week. As I write, Bloomberg headlines show it down 15% today. Although its value is backed by nothing but what the next buyer will pay, it is increasingly being considered an alternative asset class and is attracting some institutional interest. A major risk to Bitcoin and other crypto currencies, however, would be governments establishing their own digital currencies and outlawing other such currencies within their jurisdictions.

A striking example of the speculative nature of crypto currencies is Dogecoin. Started as a joke in 2013, it is now valued at $50 billion. It recently moved up by 400% in seven days, doubling in a single day. Needless to say, anything that moves like that is tough to categorize as a currency.

Then we have equity playthings like GameStop. Within the past year, the stock traded just above $3 per share with many analysts forecasting that the company was in danger of bankruptcy. In recent months, GameStop became a trading favorite of fans of the Reddit website, which promoted the idea of running the short sellers. The stock closed 2020 just below $20 per share. On Reddit-generated enthusiasm, it closed just under $350 on January 27 of this year. On the following day, the price fluctuated between just over $100 to just under $500, closing a little under $200. Since then it has traded between about $40 and $350. Analysts currently forecast that the company will lose money in each of the next three years. Nothing about this behavior resembles investment. GameStop is strictly a toy for aggressive speculators, and it epitomizes the gambling aspect in today’s stock market.

The last several months have witnessed the emergence of a phenomenon similarly hard to categorize as investment. Non-fungible tokens (NFTs) represent a certified claim of ownership of a digital asset, such as art, photos, video, etc. Within the past few months someone paid over $69 million for a collage by an artist named Beeple. Anyone can view it on the internet, but the buyer can claim ownership. That begs the question: Would the buyer have been willing to pay even a small fraction of that price to buy the physical collage? Is this merely another example of collectors searching for a new area in which to speculate?

I thought I had seen the ultimate in ludicrous speculation until this week. On April 15, the stock of Hometown International was valued at $100 million. The company CEO is a New Jersey high school wrestling coach. The company owns one delicatessen which has generated $35,000 in total sales over the past two years. The company reported about $154,000 in losses in 2019, then $624,000 in 2020. They are currently paying $25,000 per month to one consulting firm and $15,000 per month to a separate consultant. One wag suggested that some Hometown shareholders in the gambling mecca of Macau, China, must believe the pastrami sandwiches to be pretty darn tasty!

Commenting on these phenomena in its April 2021 Financial Forecast, Elliott Wave International pointed to: “investors’ record-breaking willingness to assume risk, a psychological condition that history invariably finds on the cusp of great bear markets.” No one can know, of course, whether or not we are anywhere near a great bear market, but it is instructive to recognize that extreme speculation in the past has invariably been expunged by sharply lower prices, not by prices rising to justify the speculation.

It’s not hard to find studies that show clearly that levels of valuation even well below today’s have consistently led to significant market declines. In all such past instances, one form or another of “It’s different this time” was the belief that led to disregard of past examples that could have provided valuable warnings. In my career, which dates from the late-1960s, I have witnessed such disregard of underlying fundamentals in three poignant instances: the Nifty-Fifty era in the early-1970s, the dot.com mania at the turn of the century and the housing debacle in this century’s first decade. On average, these three episodes each saw equity prices cut in half.

Could it, in fact, be different this time, and could underlying fundamentals ultimately rise to justify today’s extreme valuations? Theoretically, yes, it could. It never has turned out that way from past valuation extremes, however, which is why I continue to remind investors of market history. In addition, current conditions are unfolding in an environment of unprecedented levels of domestic and international debt, which simply compounds the risk.

This extended bull market from the end of the Financial Crisis in 2009 has been fueled by government monetary and fiscal support whenever the economy or markets have shown evidence of potentially damaging deterioration. Signs of potential weakness have appeared whenever governmental support slows. It’s a fair question to ask whether the economy can grow at anything above a crawl without government support. I know of no government that has succeeded for long in supporting its economy by consistently running massive deficits, as we have been attempting to do now for several years. Does anyone believe that government can continue to provide even a fraction of the support demonstrated in the graph below?

That powerful stimulus has produced a remarkable rally off the trough of the historic pandemic bear market, even while the economy was struggling to recover. If the virus or its variants don’t lead to another slowdown, the average forecasts of six major government and private agencies point to GDP growth in 2021 of a strong 5.65%. Forecasts for 2022 decline to an average of 3.37%, then to 2.27% in 2023. Beyond 2023, the average long-term forecast from the Congressional Budget Office and the Federal Reserve is a mere 1.75%. The long-term forecast for the Eurozone by the European Central Bank is for an even more dismal GDP growth of just 1.4%. If these forecasts are anywhere close to being accurate, corporate earnings will have difficulty growing at more than a pedestrian pace after a sharp bounce-back this year. With valuations at historic highs, how much of this year’s earnings growth is already priced in?

Although risky because of current extreme valuations, it’s a legitimate speculation that stocks can continue their upward march so long as government stimulus promotes rising GDP growth and corporate earnings. Unless that stimulus continues far longer than currently anticipated, however, precedent argues strongly that equity prices will fall to align with more historically normal levels of valuation. The question is when such a reversion to the mean would occur. Could profits earned between now and then be harvested and protected? Possibly, but timing such an exit appropriately has always been problematic. For a buy and hold approach to succeed over the full decade ahead, it will have to be “different this time”. Every investor should evaluate carefully his/her/its financial and psychological ability to withstand potentially substantial stock market volatility in the years ahead.

By Thomas J. Feeney, Managing Director, Chief Investment Officer