Clients & Friends,
In Q3, the theme of relation was ever present as we saw risk assets increase almost entirely across the board. Most people in my shoes continue to scratch their heads are we are in one of the worst economic periods in US history yet stocks continue to go up and up. And it’s not just that stocks continue to rise, but they’re continuing to rise to incredibly high valuations from already high valuations during a time of great uncertainty. Furthermore, the indices are becoming more and more concentrated as Apple, Amazon, Microsoft, Facebook, Netflix, Google and a few others weights increase within the index to record highs. In the Nasdaq, Apple, Amazon and Microsoft now represent almost 35% of the index. While valuations are more reasonable today vs. 1999/2000, they are still incredibly high on a relative basis.
So how does this make any sense? How can the markets continue to go up even though the basic economic fundamentals are so weak? The simplest answer I’ve come to is that there’s too much supply of capital/$$ which is chasing too few assets. Basically a supply/demand imbalance which is in part caused by the Fed. This is why the largest companies have gotten even larger as they have the largest float. The more shares that are available to be purchased, the easier it is to accumulate positions in them. And what has helped is that these companies have actually faired quite well in the pandemic.
To be a blind owner of stocks, you have to believe in the greater fool theory (imo) since if history is a guide, owning stocks as these valuations forecasts very low future returns. See below on the right side of the chart from JP Morgan. 1 year returns are more difficult to forecast (in my experience) than longer term returns. At today’s forward PE ratio (which might prove to be optimistic since future earnings are a guess), the regression line shows a 5 year annualized returns of close to 0%. At best (assuming the next 5 years falls in the range of past returns), we’re looking at 5-6% annualized returns. That’s not necessarily a bad return, although you’re taking a lot of risk for below average returns.
The forward PE ratio is not agreed on by all parties since not everyone agrees on what earnings will be. If you ask Bianco Research, they believe the forward PE ratio to be over 25. If you look back at the prior chart, it doesn’t look too good for returns when you’re at these levels as they’re all negative historically.
What about trailing PE ratios? We’re certainly well beyond the average sitting at 23.6X. There’s only been a few times in history where we were above these levels. With money being printed willy nilly and interest rates at all time lows, it’s possible trailing PE could hit a new record over the next 12-24 months.
?? This is the dawning of the age of euphoria, age of euphoria. Euphoria!! Markets are deep in euphoria looking at Citi’s panic/euphoria model. If market wisdom is to buy when others are fearful and sell when others are greedy, what should we be doing now? ?
What’s an ideal measure of inflation? Is it CPI or another one? I’d argue CPI completely misses asset inflation which is real inflation. Housing prices in some parts of the country have gone up an incredible amount but if you’re only looking at PCE, we’ve barely hit above 2% in the past 6-7 years. I would hypothesize that actual inflation is much higher than the data would lead you to believe (more on inflation below).
Market breadth is something that mentioned often. According to Investopedia, market breadth “indicators analyze the number of stocks advancing relative to those that are declining in a given index or on a stock exchange (such as the New York Stock Exchange or NASDAQ). Positive market breadth occurs when more stocks are advancing than are declining. This suggests that the bulls are in control of the market’s momentum and helps confirm a price rise in the index. Conversely, a disproportional number of declining securities is used to confirm bearish momentum and a downside move in the stock index.”
When you look at the S&P 500 and stocks above their 50 & 200 day moving averages and % of members at 52 week highs, you’ll see breadth isn’t as strong as the markets suggest. This is due to the fact that a small % of the S&P 500 is powering the entire index.
What she said ??✊?
Bear market? What bear market? If you blinked, you may have missed it. ?
Never get high on your own (money) supply.
I am getting more and more concerned with municipal bonds as a result of the state and local forecasted budget shortfalls due to COVID. While I don’t expect near term issues (ie. a major default in the near term), I am concerned in the longer term. A major muni default can send shockwaves through the entire market.
On the other side, if Biden is elected and taxes are raised, this could provide a boost to muni bonds as their taxable equivalent yield would be higher.
It was the best of times and the worst of times. The S&P is a tale of two cities which is the S&P 10 vs. the S&P 490. It turns out that much of the S&P 500 returns come from just 10 companies: Microsoft, Apple, Amazon, Google, Facebook, Visa, Mastercard, Nvidia, Netflix, and Adobe. As a group they are up 35% since the beginning of the year. As a group, the other 490 are down more than 10%.
Just three stocks make up more than 16% of the S&P 500 Index and over a third of the Nasdaq 100 Index. I bet you can guess which three. Apple, Amazon and Microsoft together are now valued at nearly $5 trillion. That’s larger than the entire economy of Germany and nearly the size of the Japanese economy.
What is really most astounding, though, is the aggregate valuation of these three behemoths relative to their free cash flow. Only at the peak of the Dotcom Mania did we see anything like it. The difference today is that these companies are growing free cash flow at a tiny fraction of the rate they grew it back then. If that was a bubble, then what is this?
Q2 GDP was released during the quarter and it was bad, which was expected. Turns out we lost almost 33% of GDP in Q2 on an annualized basis. Europe wasn’t spared as they saw an approximate 40% decline on an annualized basis.
As bad as it was, it wasn’t the worst we’ve ever experienced. Turns out it was only the 5th worst reading on record which might surprise some folks.
Economists are forecasting a bounce back in Q3 GDP which makes sense given we are coming off such a dismal quarter.
The number of companies who’s profits are less than the interest paid on their debts is approaching the 2000 peak. Money printing and low interest rates allows zombie companies to survive longer than they should and interrupts the creative destruction process.
California is on fire, literally. The state was already seeing an exodus of population and know many people who have moved to Austin from SF and other parts of California in recent years and see that this trend isn’t stopping. Climate change and taxes are likely to continue this trend of exodus on the state and impair its finances even further.
We’ve been hearing a lot about how cheap value is relative to growth and the relative outperformance of growth. And it’s true if you’re looking at small, mid or large cap companies. However, none of them are cheap and are all trading at premiums to their 20 year average. The outperformance of growth vs. value is likely to continue except for when we have another pullback where we’d like see value outperform growth. Value will still likely lose money but less so than growth.
In regards to inflation…
The Fed’s preferred method of inflation is the PCE index (Personal Consumption Expenditures). Very recently, Chairman Powell indicated a move from targeting 2% to average inflation targeting. That means the central bank will be more inclined to allow inflation to run higher than the 2% target before hiking rates.
In reaction to this, bond yields and inflation expectations have been rising. Looking at the 30 year bond yield, it’s moved up .30% since July 30th.
The breakeven inflation rate (represents a measure of expected inflation derived from 10-year treasury bonds) has been increasing. Since the Fed will let inflation rise past 2% before hiking rates, the markets expectation is for higher inflation.
But does this make actual sense? Should we be concerned that inflation will rise simply because the Fed will be more accepting of it? Will their money printing stoke the inflation monster? I would argue inflation is already here, although not in the way it’s measured by the PCE. Since the Fed’s 2% target for core PCE inflation was announced in January 2012, it has been hit only 11 times; given core PCE excludes food and energy, and downplays housing and healthcare costs more than any other inflation metric. By design this target is not easily met. As you can see, they’ve had a hard time getting it above 2% and keeping it there. What is going to be different this time around that they believe 2% is achievable long term?
What’s an ideal measure of inflation? Is it PCE, CPI or another one? I’d argue CPI and PCE completely miss asset inflation which is real inflation. Housing prices in some parts of the country have gone up by an incredible amount but if you’re only looking at PCE, we’ve barely hit above 2% in the past 6-7 years. Outside of 2013 when housing went up by 10%, it’s been running nationally at 5% since mid 2014 through today.
How about lumber prices and used cars? Lumber prices have surged well beyond pre-COVID levels while in August, used car sales were up 15.6% year over year.
I’ve noticed many economists would point to a rise in M2 as coincidental or a causal factor for inflation (traditionally measured). Sometimes that’s true and other times it’s not. The velocity of money is what I believe is a better predictor of inflation and it’s been falling. The velocity of money is the turnover of money in our economy and typically expressed as the ratio of GDP to money supply. Since our money supply has been growing significantly faster than GDP, velocity has been dropping.
The prices we all pay for goods have been going up. Stocks, housing, labor, cars, etc. are going up in price. Using core PCE to make these decisions is flawed itself because core PCE is weighed down by its heavy concentration of healthcare costs that are mostly priced fixed by the US government via Medicare and Medicaid reimbursement. Furthermore, letting inflation run above 2% for a period of time hurts the most least able to afford it.
Setting aside pure logic and reasoning for a moment, the Fed still can’t (won’t) hit its 2% target. The (PCE) price index, excludes food and energy to achieve a stated aim of “smoothing” the data. Excluding these two essentials is insulting in and of itself and also plain wrong if you’re expressly targeting the price burden truly being carried. What’s worse, the core PCE understates to the greatest degree of any inflation metric; the cost of healthcare and housing.
The core PCE they hide behind is, at best, deceitful. Fed officials would, however, face a dilemma if they owned up to a metric that captured true pricing, including that of assets. Inflation would long ago have run so hot we wouldn’t be in the mess we are while interest rates would be normalized sending the zombies where they belong – not just dead but buried. The irony is rents have started to, and will continue to, decline, making it that much more difficult for the Fed to keep up the ruse of their “inflation” narrative.
So while I firmly believe inflation is already here, I don’t think it’s going to show up in the ways the Fed and others are tracking it. The move toward average inflation targeting may be a tactic by the Fed to stoke inflation expectations because they fear deflation. Inflation expectations can become a self fulfilling prophecy so it’s worth a shot, especially when you don’t have many bullets left. But I hypothesize that the increases in the 30 year bond year and 10 year breakeven rate will prove transitory as bankruptcies rise and stimulus effects wear off.
Only time will tell whether the inflation monster will take hold but it certainly seems like the Fed is going to throw everything at the markets to avoid a deflationary spiral. I fully expect the Fed to take more action if we experience another bear market like we did in March since they need asset prices to remain elevated.
So while the markets may continue to rise into uncharted valuation territory, in my view the universal law of gravity will likely pull assets back to earth when the printing stops. We’ll see if Federal Reserve Chairman Icarus, I mean Powell, will fly too close to the sun with all of this printing.
I hope you enjoyed this quarters financial markets update. If you have any questions please contact us directly. If you’re interested in a topic that you’d like us to address, please email us so we can include them in future updates.
If you’re interested in starting a dialogue and learning how we can help, please contact us.
Best Regards,
Jared Toren
CEO & Founder
Sources: Edges & Odds, WSJ Daily Shot, 361 Capital, Steve Blumenthal’s On My Radar
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