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This market is a lot like a duck, it is calm on the surface but there is a lot of churning underneath.  Image: by Ruslan Khaydarov As I write this on Thursday night (7/22), the S&P is up 16% YTD and just 1% below its all-time record high on 7/12. However, there has been a violent rotation underneath this seemingly linear move higher in the S&P. Versus their 52-week highs, the Russell 2000 index has fallen 7% and the 10-year treasury yield has gone from 1.78% to 1.28%. The most recent advance in the S&P, however, has been driven by the S&P technology index which was up just 1% till May 12th and since then has advanced 17% in just over 2 months.
A few factors seem to be driving these moves including: 1) a surge in the Delta variant of Covid shutting down parts of the world again, such as no spectators being allowed at the Olympics; 2) peak growth concerns as we lap the worst of the Covid-19 shutdowns a year ago; 3) seemingly more belief in inflation being “transitory” as prices for certain commodities like lumber have gone lower; 4) 10-year Treasury yields retreating from a high of 1.78% to 1.28%. Since their highs early this year, sectors that were outperforming YTD that were geared to economies reopening and higher inflation have sold off. From their 52-week highs, the S&P energy sector is down 13% (up 29% YTD), the materials sector is down 9% (up 12% YTD), financial sector is down 6% (up 23% YTD) and the industrial sector is down 3% (up 16% YTD). Our view remains that economies will slowly continue to re-open as more people get vaccinated and reach herd immunity. The Olympics banning spectators was clearly a watershed event given it was already postponed. Having said that, roughly 3.6 billion vaccine doses have been administered worldwide. Our view has been that as the weather gets colder, much like other coronaviruses such as the flu, Covid will also see a pickup in cases. We also believe, much like the flu, that every year we will be getting a Covid shot given coronaviruses are known for rapid mutation. However, close to 30M vaccine doses are being given daily. Given the desire for humans to interact with each other, we think we will eventually develop new ways of socializing despite the presence of Covid, whether it is wearing a mask at events or getting screened before entering venues. We also believe that inflation will be more persistent than transitory. Headline/Core CPI are at 5.4%/4.5%. These are the highest levels since Aug-08/Nov-91. Core PCE, the Fed’s preferred inflation metric, averaged 1.6% for the prior decade. Any concerns about inflation due to the easy money policies following the Global Financial Crisis (GFC) have been wrong. Our view is that inflation today will be more persistent versus transitory. While clearly some increases are transitory such us comparing oil prices to negative $35 last April, other inflation components like wage and rental price increases we think will be more persistent given structural changes. “Although incoming inflation data are somewhat elevated, a portion of the increase… appears to have been due to transitory factors.” (6/30/04 FOMC statement). However, what followed was 17 rate hikes over 2 years which took the Fed funds rate from 1.00% to 5.25% that ultimately culminated in the Global Financial Crisis as the Fed dealt with inflation that was persistent not transitory. We believe wage inflation is going to be the big problem going forward and these increases are persistent and feed through to the cost of final goods and services. Average hourly earnings were up 3-3.5% in the second half of 2019 as wage pressures started to build. Currently, the Job Openings and Labor Turnover Survey (JOLTS) is 9.2M and compares to 9.3M people that are unemployed and an unemployment rate of 5.9%. It took over 8 years for the number of people unemployed and job opening to overlap following the global financial crisis versus just over a year following Covid. Average hourly earnings are already up 3.6%. We believe the unemployment rate will move down rapidly as generous extra unemployment benefits expire in September with over 20 states already starting the process before then. These wage pressures are only going to get worse as we head towards the holidays when more seasonal workers get hired. The rise in shelter prices is notable with owners' equivalent rent (OER) up 2.3% y/y and home prices up 15% y/y. April home prices, per the Case Shiller index, is up 15% y/y which is the highest since December of 2005. Owners' equivalent rent (OER) is up 2.3% y/y and is 30-40% of most inflation metrics and larger than food and energy combined. OER typically lags home prices by a year so we would expect pressure on rents to continue. And the Fed looks increasingly behind the curve as the central banks of both Russia and Brazil have raised rates three times each while England joined Canada to become one of the two G7 central bank to start tapering. Inflation has been relatively non-existent since the GFC (and arguably for 40 years) but now is picking up globally. Russia, Brazil and Turkey, are among the 19 central banks that have raised their main interest rates so far this year. In total there have been 29 rate hikes this year already. Russia’s central bank said earlier this year, "the rapid recovery of demand and elevated inflationary pressure call for an earlier return to neutral monetary policy." We believe the Fed will signal the start of their own tapering process by the August Jackson Hole meeting. The Fed continues to reiterate their belief that inflation is “transitory”, but their dot plot has 2 rate hikes in 2023 and they need only 2 more votes for a rate hike in 2022. In our opinion, inflation data for the next several months will force them to change their stance by the Jackson Hole meeting. In 2011, 2015, 2018, and 2020, the stock market fell 10-20% over 1- 5 months during periods when monetary stimulus was flat to down.
The Fed may need to act in a more disruptive manner than what they have done in the past. Historically, the Fed has acted preemptively to fend off inflation. With their new policy of waiting to see if inflation is present before acting, there is a real risk of having to reverse policy much more quickly than in the past. If inflation turns out to be more persistent than transitory, a rapid tightening in policy might be needed. With valuations at record highs, this might cause a much sharper stock market correction than seen during past tightening cycles, which can lead to slower growth in the future. This might not be a near-term concern, but it is important to monitor, as this can be a portfolio changing event in the long term. Record valuations magnify the risk to the downside given the total market cap of the US stock market divided by GDP is at a record 1.9x versus 1.4x at the peak of the tech bubble and a 50-year average of 0.8x. This incredible multiple expansion has been driven by the repression of interest rates by the Fed buying bonds. This has driven up valuations of the entire market but especially of technology stocks. We would note that this ratio went from 0.84x in late 1972 to a low of 0.35x in late 1974 due to rising inflation. It is estimated that by the end of Q1, there was also over $5.4 trillion (6% of global GDP) in excess consumer savings since the coronavirus pandemic began and the US has $2.6 trillion (12% of US GDP.) Given many activities have been halted during COVID-19, the US savings rate exploded to 34% in April 2020 from 7-8% prior to COVID-19. This is more than double the previous all-time high of 15% in 1975. Currently, this rate is sitting at 12%. When global economies reopen, this excess savings is likely to be spent and drive a surge in demand and more persistent inflation. There are many signs of a bubble, but bubbles can continue for longer than anyone suspects. Meme stock prices, Bitcoin prices, a non-fungible token (NFT) by Beeple (an unknown artist just a few years ago) selling for over $60M are just some signs of excess in this market. Former Federal Reserve Chairman Alan Greenspan famously talked about “irrational exuberance” in the financial markets. Most forget this comment was in late 1996, and the S&P peaked in March of 2000 after having more than doubled from the time of his original statement. When the current bubble eventually bursts, it will take all stocks down, not just the more speculative stocks that are being bid well beyond normal valuation metrics. Amazon had revenues of $1.6B in 1999 which grew to $3.1B by 2001 but the stock however went from $106 at its peak in 1999 to $6 at its lows in 2001 when the bubble broke. Roughly 4000 other internet related companies went out of business. Some of the most exciting technologies of today such as artificial intelligence, bio-technology blockchain, crypto currencies, digital banking, electric vehicles, green energy and virtual reality, are likely to change the world much like e-commerce did in the late 1990s. This does not mean that investments in this space cannot get crushed if history is any guide. Our hope is that our shorts will outperform when this bubble breaks and enable us to cushion the portfolio against a correction much like in Q1 of 2020 during the emergence of COVID-19. In addition, our longs are primarily stocks that have growth at a reasonable price (GARP) that we believe will decline much less during a market correction. Risk management for both our long and short positions is key in this environment. In Summary The drivers for the US stock market record highs remain the same:
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 We expect unemployment to drop faster than expected. Job openings & the number of unemployed are both at 9.3M w/ extra unemployment benefits expiring, the # vaccinated increasing & in person schooling in the Fall. This will put pressure on the Fed to hike/taper sooner.
As I write this today (6/14), the S&P is up 13% YTD and at an all-time record high. The S&P recovered from its sharpest sell-off in the S&P (down 4% in three days ending 5/12) since late October of last year. This was driven by inflation data that continues to come in stronger than anticipated. Interestingly, the 10 year treasury yield has declined from 1.75% on 3/31 to 1.49% today and sits at levels from last March.
Statement from Fed officials continue to stress that the current surge in inflation metrics is “transitory” and it seems the market is willing to believe it judging by the decline in treasury yields. Headline CPI now stands a +5.0% and core CPI now stands at +3.8% on a y/y basis. We, however, continue to believe that though some of the increase in inflation is due obviously to “base effects” like oil prices going negative at one point last year, the increase we are seeing in wages is only going to get worse. Some of these wage increases are being affected by the inability to hire enough workers due to generous unemployment benefits, Covid safety concerns and inadequate childcare. But let us not forget that unemployment before the pandemic was at its lowest levels at 3.5% since the 1960s. As a result, average hourly earnings were up 3-3.5% in the second half of 2019 as wage pressures started to build. McDonald’s is currently using signing bonuses to attract workers. These wage pressures are only going to get worse as global economies open up and we head towards the holiday season. The rise in shelter prices is notable with owners' equivalent rent (OER) up 0.31% in May, the largest increase since June ‘19. Given the number of people moving from large cities to suburbs given new work from home flexibility, we find this interesting. OER is over one quarter of CPI, and larger than food and energy combined given housing costs is a big component of the average consumers budget. This increase in OER potentially means home prices which are now up 13% y/y and increasing at the fastest pace since 2005 is offsetting higher vacancy rates in big cities. The drivers for the stock market record highs remain the same: 1) the Fed balance sheet hit a new record of $7.95 trillion and is up 11% y/y after being up 77% last year, 2) money supply is up a record 18% y/y (peaked at 27% in Feb) vs a peak of 10% during the GFC, 3) vaccinations continue and 4) the macro data is strong with S&P EPS now forecasted up 50% in 2021, and 5) the employment picture continues to improve with weekly jobless claims below 400K for the first time since the Pandemic. Looking forward, the Biden administration is trying to pass another $4 trillion in stimulus ($1.8 trillion American Families Plan and $2.2 trillion Infrastructure Plan.) But the central banks of both Russia and Brazil have raised rates multiple times while England joined Canada to become the two G7 central bank to start tapering. Russia, Brazil and Turkey, are among the 14 central banks that have raised their main interest rates so far this year. In total there have been 22 rate hikes this year already. Russia’s central bank said earlier this year, "the rapid recovery of demand and elevated inflationary pressure call for an earlier return to neutral monetary policy." We believe the Fed will signal the start of their own tapering process by the August Jackson Hole meeting at the latest. The Fed continues to reiterate their belief that inflation is “transitory” and say they will not be raising rates through 2023. We believe that inflation data for the next several months will force them to change their stance. Stimulus has been incredibly important during this last decade for markets and when it needs to be dialed back (tapered) due to inflation concerns, this could be an issue as we have seen in the past. The Fed purchases of $40B a month in mortgage-backed securities in particular seems to make no sense. “The housing sector has more than fully recovered from the downturn,” Chairman of the Fed, Jerome Powell, said last month at a press conference. In 2011, 2015, 2018, and 2020, the stock market fell 10-20% over 1- 5 months during periods when monetary stimulus was flat to down.
In a world with declining inflation since 1981 and especially since the Global Financial Crisis (GFC), bond and equity portfolio returns have both been very strong. Following the GFC, the Fed and other governments around the globe bought bonds to drive down interest rates. By December of 2020, there was over $18 trillion in government debt with a negative yield to maturity as bond returns were super-charged by Central Banks around the globe. With 10-year treasury yields hitting a record low of 0.5% in August of 2020, this in turn drove very strong returns in the equity markets, especially in long duration assets like technology stocks. Inflation has been relatively non-existent since the GFC (and arguably for 40 years) but now is picking up globally. Any concerns about inflation due to the easy money policies following the GFC have been wrong. Core PCE, the Fed’s preferred inflation metric, averaged 1.6% for the prior decade. This has enabled the Fed to expand its balance sheet for over twelve years from $900B before the financial crisis to $8.0 trillion currently. The Fed is currently buying $80B in Treasuries and $40B in mortgage-backed securities per month until there is “substantial further progress” in meeting its goals on employment and inflation. Annualized, this is $1.4 trillion or 7% of GDP in further stimulus from the Fed expected in 2021. Core/headline PCE and CPI are between 3.1-5.0% in the US. US GDP growth following the GFC from 2010 to 2019 averaged 2.3%. This was the slowest recovery following a recession since World War II. As a result, companies continued to cut back on capacity expansion to match the lower-than-expected growth. In 2020 following the pandemic, capex was cut back particularly hard as many companies just tried to survive the unprecedented drop in prices. As a reminder, oil got to NEGATIVE $35 dollars per barrel at one point. However, US GDP growth is expected to be ~7% in 2021, the fastest since 1984 at 7.2%. World GDP growth is expected to be 6%, the highest since 1976, after falling 3.3% in 2020. We believe, this surge in GDP growth combined with low capital expenditures will lead to a persistent, not “transitory”, increase in inflation. The Fed may need to act in a more disruptive manner than in the past when they do act. Historically, the Fed has acted to preemptively head of off inflation. With their new policy of waiting to see inflation before acting, there is a real risk of them having to reverse policy rapidly versus the gradual pace seen in the past when they do act. If inflation, turns out to be much stronger than expected, a rapid tightening in policy might be needed and with valuations at record highs, this might cause a much sharper stock market correction than seen during past tightening cycles with a higher risk of a sharper slowdown in future growth. This is obviously not a near-term concern but worth keeping in the back of your mind. Money Supply (M2) is up 18% y/y vs. a prior record of 14% set in the 1970s, and a high of 10% during the GFC and 10-year yields are at 1.5% after starting the year at 0.9%. When rates moved up from 1.39% to 1.52% on February 25th with an intraday high of 1.61%, a 7-8 standard deviation event, the S&P was hit for 2.4% and gold was hit for 2% and the commodity index was down 0.3%. This is a problem for portfolio managers if both bonds and stocks sell-off together. There are four large investors that like to have close to a fixed ratio between bonds and equities: balanced mutual funds, US defined benefit pension plans, the Norwegian oil fund, and the Japanese government pension plan. These four alone accounts for ~$8 Trillion in assets. Driven by stimulus, the total market cap of the US stock market divided by GDP is at a record 1.9x versus 1.4x at the peak of the tech bubble and a 50-year average of 0.8x. This incredible multiple expansion has been driven by the repression of interest rates by the Fed buying bonds which has driven up valuations of the entire market but especially of technology stocks. We would note that this ratio went from 0.84x in late 1972 to a low of 0.35x in late 1974 driven by rising inflation. The trailing S&P500 PE during this time went from 20x to 7x despite earnings rising 50% from 1972 to 1974. The trailing PE today is 30x. The PE is also being held lower by record profit margins and buybacks. Inflation is likely to eat into margins along with the higher corporate tax rates being proposed. But both Treasury Secretary Janet Yellen and Federal Reserve Chairman Jerome Powell seem to be changing their stance on the impact of monetary policy on the economy and the stock market. Earlier this year Treasury Secretary Janet Yellen urged lawmakers to “act big” and not worry about deficits for now, given low interest rates on that debt. However, on May 4th, she said “interest rates will have to rise somewhat to make sure our economy doesn’t overheat.” Federal Reserve Chairman Jerome Powell has also consistently pushed back on the need to even think about raising rates. However, at the Q&A for the FOMC meeting on April 28th he said, “You are seeing things in the capital markets that are a bit frothy, that’s a fact…I won’t say it has nothing to do with monetary policy, but also it has a tremendous amount to do with vaccination and reopening of the economy.” The Q&A following the Fed meeting this week could be very interesting. It is estimated that by the end of Q1 of 2021, there was also over $5.4 trillion (6% of global GDP) in excess consumer savings since the coronavirus pandemic began and the US has $2.6 trillion (12% of US GDP.) Given many activities have been curtailed during COVID-19, the US savings rate exploded to 34% in April 2020 from 7-8% prior to COVID-19, and an all-time high of 15% in 1975. This rate is currently at 15%. When global economies reopen, this excess savings is likely to be spent and drive a surge in demand. There are many signs of a bubble, but bubbles can continue for longer than anyone suspects. Meme stock prices, Bitcoin prices, a non-fungible token (NFT) by Beeple (an unknown artist just a few years ago) selling for over $60M are just some signs of excess in this market. Former Federal Reserve Chairman Alan Greenspan famously talked about “irrational exuberance” in the financial markets. Most forget this comment was in late 1996, and the S&P peaked in March of 2000 after having more than doubled from the time of his original statement. When the current bubble eventually bursts, it will take all stocks down, not just the more speculative stocks that are being bid well beyond normal valuation metrics. Amazon had revenues of $1.6B in 1999 which grew to $3.1B by 2001 but the stock however went from $106 at its peak in 1999 to $6 at its lows in 2001 when the bubble broke. Roughly 4000 other internet related companies went out of business which dragged down Amazon with it. Some of the most exciting technologies of today such as artificial intelligence, bio-technology blockchain, crypto currencies, digital banking, electric vehicles, green energy and virtual reality, are likely to change the world much like e-commerce did in the late 1990s. This does not mean that investments in this space cannot get crushed if history is any guide. In Q1 of 2020, while the market went down 20%, we were profitable in large part due to our shorts that we used to hedge against the coronavirus risk. Our hope is that our shorts will outperform when this bubble breaks as well and enable us to cushion against a correction much like they did during the emergence of COVID-19. In addition, our longs are primarily stocks that have growth at a reasonable price (GARP) that we believe will decline much less during a market correction. Risk management for both our long and short positions is key in this environment. We advise investors to be careful with the market at all-time record highs and all-time valuation highs going into the Fed meetings coming up between now and year-end. The question is not IF the Fed tapers but WHEN they taper. History has not been kind to the market when the Fed balance sheet has shrunk in the past. Last Friday, news surfaced that forced liquidation of at least one large leveraged Asian hedge fund, forced block sales in several media companies and Chinese ADRs including:
Typically, there is always some collateral damage following these types of intense moves that are lower on heavy volume with some of the names above down more than 50% from their highs just a week ago. At the extreme end, in 1998, the failure of the highly levered hedge fund, Long-Term Capital Management almost caused a collapse in the financial system before an organized rescue by the Federal Reserve. As a result of the large moves lower caused by this forced liquidation, we started nibbling on a few of the names above on Friday (3/26) with the knowledge that there was the possibility of contagion during this upcoming week. More forced liquidations might give us even better prices to fill out our positions. For risk management, we also shorted the S&P to hedge these positions given the 1.7% upward move on Friday, despite the large moves downwards in these individual names and related securities during the week. Viacom ($VIAC) is a name that we mentioned on 9/25/20. The stock was at $30. We thought the stock could rerate higher based on their ramping streaming business. “VIACOMCBS, AN UNDER THE RADAR, DEFENSIVE PLAY ON VIDEO STREAMING” danniles.com/articles/09-25-20 However, as the stock ramped for a variety of reasons over the past six months, we sold the stock and tried to put that money into names in under-appreciated sectors such as energy and financial. Viacom intelligently fortified their balance sheet by raising $3B in capital when the stock reached an all-time record high on 3/24/21. Viacom’s stock has now declined from $100 on 3/24/21 in just 4 trading days to $48 on Friday. As a result, we started nibbling on this name along with a couple of others. In terms of fundamentals, Viacom should see their advertising revenues continue to recover if GDP growth improves to ~7% in 2021. In addition, their streaming business should continue to thrive as more households adopt multiple streaming services beyond Netflix. In terms of risk, the pandemic accelerated cord-cutting, but with the stock now trading at a price to earnings ratio of 11x 2021 EPS compared to the S&P at 23x, the risk to reward to owning the name should be favorable again. Our goal for this next week would be to add to this position (and others) if weakening persists while hedging these positions with additional shorts. The S&P 500 was up 18% on a total return basis in 2020 driven primarily by a 77% expansion in the Federal Reserve Balance sheet to $7.4 trillion from $4.2 trillion and nearly $4 trillion in government stimulus. The fastest drop in history from an all-time high to down 30% for the S&P was rapidly regained and forgotten. Simple way to think about the fedThe Federal has multiple ways to stimulate economic growth including: 1) The Federal Funds rate, 2) the purchase of assets such as bonds (Quantitative Easing) which shows up on the Federal Reserve Balance Sheet, and 3) regulation, including capital requirements like the Supplementary Leverage Ratio (SLR), on banks that lend to corporations and individuals. Simply, there is the rate you can borrow loans at, the amount of loans available to borrow, and the restrictions on how to get the loans. The reason low interest rates are a way to stimulate the economy is because it makes debt cheaper to borrow to finance spending for corporations as well as consumer purchases of goods like homes and automobiles. However, even if interest rates are low, if the Fed restricts the ability of banks to lend, while loans may have a low interest, they are harder to come by. This effectively begins to “taper” the easy money policies that have been in effect since the Global Financial Crisis and particularly since the advent of Covid. One easy way to measure the impact of Fed policy is by looking at the supply of money in the market (M2). If the money supply is up a lot year-over-year, then it is easy for consumers and corporations to get money. If the supply of money starts to contract, then it gets harder. Money Supply (M2) is up 26% y/y vs a prior record of 14% set in the 1970s, and a high of 10% during the global financial crisis. THe Recent Sell offAs I write this today (3/19), the S&P hit another record high on 3/17 (up 5.8% YTD) with stimulus checks and Fed balance sheet expansion driving it higher. Stimulus checks from the $1.9 Trillion Covid relief package reached consumers this week. According to a Deutsche Bank survey, retail investors planned to put 37% of any forthcoming stimulus checks directly into stocks, which could represent $170 billion. In addition, the Federal Reserve Balance sheet hit a new record high of $7.7 trillion on 3/17 (up 65% y/y.) The market sold off to end the week following the Fed meeting and their decision not to extend the SLR which to us starts the process of a stealth tapering. The SLR was an emergency move put in a year ago by the Fed that allowed banks to exclude U.S. Treasuries and reserves at the Federal Reserve from the Supplemental Leverage Ratio calculation. Simply put, this allowed banks to hold less capital and lend more money during the recession caused by Covid. The Fed, in our opinion, signaled on 3/17 that they might not extend the Supplementary Leverage Ratio (SLR) when they hiked the Reverse Repo counterparty limit from $30 billion to $80 billion. This is in sharp contrast with the comments by the Fed which were clearly meant to be very accommodative. The Fed said on 3/17, “the fundamental change in our framework is that we're not going to act preemptively based on forecast for the most part, and we're going to wait to see actual data." However, their actions on the SLR to us were the beginning of a stealth tightening process despite what they said. To us, the Fed actions speak louder than words, so we positioned ourselves accordingly. On 3/18, we added a large short on against our bank longs in addition to our prior shorts, including on the S&P500. These additional shorts proved useful as on 3/19 where before the open, the Fed announced that they would not extend the SLR and financial stocks got hit. We covered the recent shorts on the S&P500 on Friday following the selloff over the prior 2 days. Outlook on the FutureWe see a rate hike coming in the future and believe the fed will have to taper their $120B in bond purchases per month before the end of the year. 4 Fed members see rate hikes possible in 2022 up from 1 in Dec. Also seven of the 18 policymakers expect see one or more rate hikes possible by 2023 up from five in December. If the Fed wants to raise rates, obviously the Fed will need to taper bond purchases first. If they are moving up the timeline on rates going up, by implication, so is the timeline on tapering. Our belief is that the Fed is slowly trying to get the market adjusted to this tapering through their actions even if their words are different.
Stimulus has been incredibly important during this last decade for markets and when it needs to be tapered due to inflation concerns, this could be an issue as we have seen in the past. In 2011, 2015, 2018, and 2020, the stock market fell 10-20% over 1- 5 months during periods when monetary stimulus was flat to down.
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AuthorDan Niles is founder and portfolio manager for the Satori Fund, a tech-focused hedge fund. Archives
June 2021
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