2021 2nd Quarter Market Commentary

If we’re unconcerned about the price we pay, there are several reasons to buy stocks today. Thanks to copious stimulus from the Federal Reserve, common stock indexes have continued their march upward, and most securities analysts are forecasting further gains. Notwithstanding the Fed’s generosity, however, U.S. Treasury notes and bonds and investment-grade corporates  lost money in this year’s first half. As I write in mid-July, the yield on risk-free 3-month Treasury bills is a mere 0.055% annualized. That effectively translates into a return of 14 cents for every $1,000 you loan to the U.S. Government for the next three months. Such meager returns have resurrected the once-popular acronym TINA (There is no alternative.) with reference to stocks.

The Fed and other major central banks continue to support economic growth with historically low interest rates and ongoing stimulus. Multiple vaccines have produced significant progress against Covid-19. Past stimulus has produced substantial personal savings, which represents significant future buying power. The vast majority of investors and investment advisors remain bullish. Bank of America has estimated that if the pace of inflows to equity funds continues at the same rate for the rest of the year, the funds will take in more money in 2021 than in the previous 20 years combined. It certainly appears that ammunition is in place to push stocks higher so long as nothing motivates sellers to become far more aggressive than they have been so far this year.

Another factor in the plus column is that equity markets rise more often than they fall —recently far more often. And in this country at least, betting that market prices will eventually move higher has always proved to be a winning wager.

There is another phenomenon, however, that, until the last dozen years, has also always proved reliable. For as long as we have had accurate records— for the better part of two centuries—market prices have always ultimately reverted to their fundamental means. When the government began to interfere mightily in the investment markets during the Financial Crisis, that pattern was put on hold.

Over the decades, reversions to the mean have not posed major problems when levels of overvaluation have been moderate. They have, however, posed serious, long-lasting problems when valuations have risen to extremes, as they have currently. In fact, a composite of all major valuation measures recently reached an all-time high. It is instructive to remember that prior reversions from levels of extreme overvaluations have erased well more than a decade of price gains and have seen markets take many years to climb back to prior peaks—a full quarter century after the 1929-32 crash.

For first-time readers, and as a reminder to regular readers, the greatest reversion of all in a major developed country was the precipitous decline in Japan from the last trading day of 1989. After years of unparalleled valuation extremes, Japanese equity prices plummeted by more than 80%. Prior to the decline, Japan had the largest stock market in the world, and investors believed that Japanese industry was in control of the new industrial paradigm. The Nikkei has since never come close to its 1989 high, and today, more than three decades later, is still almost 30% below that peak overvaluation. Such a monumental decline does not necessarily serve as a forecast for the US market but rather as a caution. Forecasts are opinions; valuations are facts. In this country, valuation extremes even remotely approaching current levels have eventually always been penalized by painful declines that drove many equity holders to the sidelines.

What current conditions might precipitate a meaningful decline? While extreme valuations have always ultimately been good guides to future market performance, they have not been good short-term timing tools. Rising inflation is creating great concern in the analyst community in recent weeks. While Fed Chairman Jay Powell has steadfastly maintained that such increases in inflation are transitory, there is a growing chorus in the investment community that believes that rising prices will prove to be more durable than expected. This could lead to higher long-term interest rates and could force the Fed to taper its bond purchases and raise short rates sooner than investors expect. In light of the market’s negative reaction to the Fed’s attempt to taper in 2013, there is reason to be concerned about another tapering attempt with unemployment, debt and equity valuations at far higher levels today. Higher taxes are being proposed and will be debated —never a positive influence on stock prices. In light of the infectiousness and virulence of the Covid-19 variants, business reclosures cannot be ruled out. San Francisco Fed President Mary Daly recently warned of global economic recovery risks from a spread of the Delta coronavirus variant and low vaccination rates in some parts of the world.

Perhaps most concerning for longer-term prospects for continued equity success is the consensus of forecasters on economic growth beyond the strong 2021 bounceback year. Forecasts for US 2022 growth range from 3.2% to 5.0% with the majority of forecasts at the lower end. Forecasts decline markedly for 2023 with the majority around 2.3%. The Federal Reserve expects longer-term growth to descend to an average of 1.9%, and the Congressional Budget Office sees an even lower 1.5% average. The European Central Bank looks for a mere 1.4% long-term growth rate in the Eurozone. It is extremely difficult to reconcile today’s valuation levels with economists’ expectations of progressively slowing US and global economic growth for the foreseeable future. Today’s stock market seems to be pricing in far better economic growth than is the consensus of economic forecasters.

Major stock market peaks have typically been accompanied by extreme speculation. 2021 has seen an explosion of speculative activities. Since current levels of speculation could be succeeded by even more egregious speculative activities, there is no way to point with certainty to the timing of a stock market peak. The following dynamics however, indicate that we have already reached a historic level of speculation.

As indicated above, investment grade bonds lost money in 2021’s first half, while junk bonds provided a small positive return, and CCC-rated bonds—companies one step from bankruptcy—returned a robust 7.3%. In July, junk bond yields descended to 3.9% —their lowest rate on record and the first time ever below the rate of inflation, currently 5.4%. In other words, this is the first time that junk bonds have provided a negative real yield. By comparison, junk bonds yielded 11% in early 2020 and well over 20% during the Financial Crisis.

Cryptocurrency Bitcoin rallied to just under $65,000 in April. It is currently trading at less than half that price.

The July issue of the Elliott Wave Financial Forecast points out that the past 12 months have seen a record net loss among companies selling additional shares to the public in secondary offerings. The only earlier time when there was a 12-month negative figure was in March 2000, just before the 2000 to 2002 market crash. Among companies going public for the first time in late-2020, 12 companies were losing money for every one that was profitable. This trend compares with a 6 to 1 ratio in March 2000 at the peak of the dot.com mania.

Margin debt recently reached an all-time high relative to GDP, as investors borrow aggressively to buy more stock.

Elliott Wave pointed out that in the Russell 3000 Index, there are 726 companies whose earnings don’t even cover their interest payments (Zombie Stocks). The zombie companies were up an average of 30% in the first half, far more than the remainder of the index. Investors seem enthralled with high risk investments.

We wrote about some of the remarkable volatility and returns in meme stocks like GameStop and AMC in last quarter’s Commentary. Meme stock speculators obviously care nothing about company fundamentals, as they tend to buy even more when bad news is announced. Outrageous volatility still characterizes the group, but a basket of meme stocks has declined more than 25% since early June. While this may indicate that the bloom is off the rose for meme stocks, there is an increasing army of new young investors who have flocked to the Robinhood trading platform over the past year. Robinhood added 11 million new accounts in the past year to bring its total to 18 million. That’s a huge number of people who have evidenced a profound interest in pursuing highly speculative investments. Legendary investor Jeremy Grantham identified meme investors as on the biggest US fantasy trip ever in the stock market.

Nobody knows how, when or at what level this stock market rally will end. The government continues to provide an unprecedented flood of stimulus. At the same time, investors are paying the most ever per unit of equity value. Markets today are more overvalued and more overbought than ever before, while the government is handing out virtually free money more comprehensively than ever before. Notwithstanding the rise of inflation discussed earlier, the Fed is not likely to abandon the stock market if it starts to retreat in earnest. More stimulus as part of a “not on my watch” approach is a likely choice— a continuation of what the Fed has done since 2008. That strategy could, however, serve to devalue the dollar to an extreme degree unless other major countries adopt the same policy. Should other countries choose a more sober and traditional monetary approach, US stocks would likely become even more overvalued relative to those in other lands.

It has almost always been older analysts and strategists that reject “It’s different this time” rhetoric, the theme song of each new generation attempting to justify economic or market extremes. Until 2009, the old folks had always been right. Has the Fed so changed the game since then that it truly is different this time? The only acceptable reason to believe that would be what we speculated about years ago—that the Fed could successfully inflate the price of everything. Betting on the unprecedented, however, is almost always a long shot.

I suspect that current equity prices can only be justified relative to valuations if the Fed and the rest of government is willing to give up defending the US dollar as the reserve currency—a step with monumental worldwide implications. In the long run, they may have no choice. But the more likely outcome is that the Fed will ultimately try to inflate much of the country’s debt away while attempting to keep the dollar as the reserve currency— a result that would likely lead to great market volatility and potentially significant declines.

For those who want to ride the momentum of the free money era, it’s important to recognize that, unless it truly is different this time, realizing a profit from current levels without suffering substantial declines first will necessitate a timely sale at some point. If current extreme valuations appear acceptable, it would be important to identify what conditions would produce an appropriate signal to sell.

If investors listen to financial TV and read the financial press regularly, they’re exposed to countless opinions and suggested investment approaches. A few weeks ago, The Wall Street Journal related the counsel of John Skjervem, former Chief Investment Officer of the $100 billion Oregon State Treasury. In an era of historically low interest rates, he said that all investors face three basic choices: 1) You can raise your existing holdings of traditional risky assets like stocks, which are certainly not cheap; 2) You can add a bunch of new and exotic bets and hope they don’t blow up on you; or 3) You can grit your teeth and stay the course through a period of what may be lackluster returns, until interest rates finally normalize. He said: “People are looking for the silver bullet, the magic wand, the get-out-of-jail-free card. There isn’t one.”

In this highly problematic environment, we remain available to respond to your questions or concerns. We are eager to understand any changes in your desire to accept or avoid investment risk in a period in which market returns could move strongly in either direction.

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