Can the Fed Prevent Overvalued Market Leaders from Falling?
For several years, investors have wrestled with a profound dilemma. With Federal Reserve and other substantial government stimulus, stock prices have risen to and remained at valuation levels that have, throughout history, ultimately been severely punished. As the years rolled on and the Fed consistently provided one sort of stimulus or another whenever stocks appeared in danger of a significant decline, investors’ confidence grew that the Fed would be there indefinitely whenever serious danger approached. As time passed, stocks moved from higher to even higher levels of overvaluation.
At our various seminars and in commentaries, I have regularly indicated our belief that, even if prices rose for a while longer, it was highly probable that severe overvaluation would ultimately lead to prices falling low enough to reduce them to or below historically normal levels of valuation. After all, that was the unbroken message of US market history. And betting on the unprecedented is rarely a profitable enterprise.
A few years ago, I speculated at one seminar on what might possibly break the pattern of severely overvalued stock markets ultimately reverting to or below their long-term means. I anticipated that the most logical scenario would be one in which the Fed would simply create so much new money that it would inflate a broad array of prices, including equity investments. In recent years, the explosive production of new money has been an integral ingredient in the rise of stock prices to successive new highs, even though that new money creation has failed so far to raise broader inflation measures even to the Fed’s minimal 2% target.
While the Standard & Poor’s 500 and the Nasdaq Composite are trading at all-time highs, the Dow Jones Industrials and the best measure of average stocks, the New York Stock Exchange Index, have not reached earlier highs. In fact, the latter index is still at levels first reached two and a half years ago. The extraordinary price elevation of the top five, six or seven investor favorites—Apple, Amazon, Microsoft, Facebook, Google, Netflix and Tesla—have had a disproportionate influence on indexes that give greater weight to stocks with larger capitalizations. In the third week of August, the five largest stocks in the S&P 500 had returned 35% year-to-date, while the remaining 495 had declined by 5%. Among the Dow Jones 30 Industrials, 11 were up for the year with 19 down.
That narrowing breadth has funneled investor concentration toward the relatively small number of stocks with strong positive momentum. The more the leaders have risen, the more investors have limited their focus to the rising giants, which in turn has produced some astonishing levels of historic valuation. Those elevated valuations raised valuations and levels of speculation in even broader equity universes. Less than two weeks ago, the excellent Ned Davis Research service enumerated several examples: “Both domestic and global equity mutual funds have never been as fully invested as they are now. A ratio of stock prices to GDP is higher than even at the bubble peaks in 2000 or 1929. The median P/E ratio of NYSE common stocks is at record highs, as are stocks-to-forward earnings globally.” As I write, the Generally Accepted Accounting Principles (GAAP) PE for the S&P 500 is above 35 times earnings. If S&P’s estimates for its own 500 stock index are correct for the third and fourth quarters, the GAAP PE for full-year 2020 will be over 39 times earnings.
Unparalleled government assistance has led to a powerful economic bounce from the dire conditions seen earlier in the year. There is little certainty, however, about the course of Covid-19 and its future impact on the domestic and world economies. In late-April, Fed Chair Jay Powell speculated that the pandemic may have serious deleterious effects on the economy over the next two or three years. It is also noteworthy that even before the pandemic, major world central banks and respected economic forecasting organizations were anticipating far below average long-term GDP growth in both the US and the Eurozone.
So far, the Fed’s monetary policies have covered up massive economic distress. While nominal GDP fell by an annualized $2.3 trillion in this year’s first half, the Fed helped raise the money supply by an even larger $2.9 trillion, and the budget deficit soared by $1.9 trillion— equaling $4.8 trillion in total stimulus. And the Fed has pledged to continue on that path so long as the economy remains too weak to support maximum employment. No one knows how they will react if inflation begins to rise above about 2.5%.
So powerful have been advances of the big seven that, with the possible exception of Tesla, few investors can even conceive of destructive price declines. Unfortunately, that belief has preceded some of the biggest losses among investor favorites of the past half century. Throughout my investment career since the late-1960s, technology has always been considered the industry of the future, and has also been the leader. That status notwithstanding, massive intermittent losses and numerous bankruptcies have occurred for even the most popular stocks of the day.
In the 1970s and 1980s, as the computer industry grew increasingly robust, there were a great many shooting stars, many of which flamed out. While it is no longer today the industry leader that it was earlier, IBM is one of earlier giants that survived and prospered, but not without some painful declines. In 1973 and 1974, Big Blue declined by almost 60%; in 1987, by about 43% in three months, continuing down to about a 77% loss by 1993; by about 61% from 1999 to 2002; and by another 47% in four months of 2008.
At the peak of the dot.com mania, Cisco was the Apple of its day, with the largest market capitalization in the world. Spectacular as has been Apple’s ascent to today’s lofty price, Cisco’s growth was even more stunning—up by more than 700% in the year and a half before its peak. Nobody could have foreseen its 90% waterfall decline in just over a year. Cisco today is still down almost 50% from its price of two decades ago.
Microsoft, one of today’s investor favorites, held a similar position at the turn of the century. Up by about 1,200% in four years, few could envision a significant decline, even in a bear market. Microsoft gave up two-thirds of its peak price in one year and remained 75% lower more than nine years later.
These are not cherry-picked examples. The Nifty 50 in the early 1970s were a broader example of today’s favorites. They were widely seen as one-decision stocks, simply to be bought and held indefinitely. Over the years, several went bankrupt. Led by the Nifty 50, the S&P 500 soared by over 70% in the two and a half years to its late-1972 peak. The index then gave up all of that and more in less than two years.
More recently, the Nasdaq Composite exploded upward by about 265% in roughly a year and a half to its 2000 peak. That index gave it all back in a symmetrically similar period of time, then preceded even lower, remaining more than 75% below its peak nine years later.
These examples are not a forecast of what lies ahead. They are, however, a caution against falling prey to overconfidence born of powerful and persistent market or individual stock advances. Markets have a longstanding habit of upending such confident beliefs when they become too one-sided.
Is there reason to believe that such a decline will not be the ultimate fate of this prolonged market advance? Possibly, even though it would set a precedent. Fed activity in recent years shows a blatant disregard for the burgeoning national debt load. Should the Fed stay true to its expressed intent to provide whatever additional stimulus is necessary to maintain maximum employment, it is very likely that the rest of the world will reach a point —if they have not already —at which they will insist on something other than the US dollar as the world’s reserve currency. Released from concern of protecting our reserve currency status, the Fed could continue the flood of new money, leading to seriously inflated prices of goods and services as well as financial assets. Such a dramatic step would change our economy and our lives in ways that would be difficult to predict with precision. And, by the way, as there is a contentious and meaningful election upcoming in November, there is little likelihood that the Fed will soon become more circumspect.
As stated earlier, the unprecedented is rarely a profitable bet, so keeping unlimited money flowing is probably still a long shot. It is not, however, an impossibility. The willingness to pour massive amounts of money into markets and individual stocks stretching all-time high valuations could reflect a current willingness of some speculators to take that bet.
By Thomas J. Feeney, Chief Investment Officer, Managing Director