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Higher Taxes Likely on the Way

Rotunda, US Capitol Dome Statues Inside Washington DC Painted by Constantino Burundi 1865

Changing legislation is an unavoidable part of investing. We’re still only a few months into the Biden administration, but there are already multiple major legislative agendas being presented by the president Biden that could affect many investors.

One aspect of his agenda was revealed in late April when President Biden proposed an increase in the tax on capital gains to 39.6% from 20% for those Americans who earn more than $1 million.1

Stocks dropped on the news, with the Standard & Poor’s 500 index down nearly 1% for the day.2

The “sell first, analyze later” reaction was curious since both Main Street and Wall Street largely expected the proposal. Several times on the campaign trail Biden said he wanted America’s wealthiest households to contribute more as a percentage of their income.3

However, the speed at which the legislation was proposed caught many off guard, including us.

A Long Road Ahead

It’s critical to remember that any capital gains tax proposal will likely face a long, uphill battle before becoming law. One prominent investment bank already has said it projects a more modest increase in the rate, which may land at around 28%.4

So at this point, it’s uncertain what type of legislation will be taken up by Congress. Challenge yourself to be patient during this period of debate and uncertainty.

We’re keeping a close eye on the process, and we are starting to analyze what a higher capital gains tax may mean for portfolios.

Some initial thoughts are:

  1. Tactical portfolios may become more attractive than traditional buy-and-hold strategies. If long-term gains don’t provide any real tax benefit, it could make sense to have a shorter timeframe when thinking about how long to hold an investment.
  2. A big benefit of holding real estate longer term may go away. There is a proposal to eliminate, or at least drastically change, the 1031 tax deferral option.
  3. The situation is very fluid. Many times, so-called “trial balloons” are floated in the public to gauge how people may respond to parts of major legislation. This helps politicians avoid putting something into law that is extremely unfavorable to a majority of Americans.

If you are concerned about capital gains—or any other proposals being debated on Capitol Hill—please give us a call. We’d welcome the chance to hear your perspective, and while we’re not CPAs, we can provide some guidance on strategies for your portfolio.

1. Bloomberg.com, April 22, 2021
2. FoxBusiness.com, April 22, 2021
3. CNBC.com, April 22, 2021
4. Markets.BusinessInsider.com, April 23, 2021

The Icarus Market

The myth of Icarus warned of the dangers of over-confidence. If we compared the markets to the flight of Icarus, how close are we to the sun? Close enough to melt our wings?

“Well, I think we tried very hard not to be overconfident, because when you get overconfident, that’s when something snaps up and bites you.”

-Neil Armstrong

The myth of Icarus we know today has its roots in the classical narrative poem, Metamorphoses, written by Ovid in the year 8 AD. In it, Icarus flies his wings of feathers and wax too close to the sun, and pays the ultimate price when the sun melts the wax and he plummets from the sky and drowns in the sea.

Before his flight, Icarus had warnings. His father, Daedalus, tested the wings and instructed him to fly neither too close to the sun, nor to the sea. Icarus, like most young adult children, ignored his father’s advice. But there must have been other warnings as well. Surely he felt the heat of the sun or the drip of the wax as his wings came apart in flight.

But filled with excitement and over-confidence, he kept his arms flapping as the wax melted off, and soon realized that his feathers were gone. He fell past his father to his demise.

It’s a tragic story of personal hubris that led to self-destruction.

Many people throughout history have suffered from the same flaws that Icarus did so many centuries ago. Napoleon invaded Russia. Japan bombed Pearl Harbor. People bought GameStop stock.

The classic lesson we can learn as investors is “don’t fly too close to the sun.”

But there is another lesson in this story as well. Daedalus’ not only warned Icarus to avoid flying too high…he warned him to not fly too close the sea as well.

What if Icarus was too cautious with his wings? What if instead of flying too high and drowning, he simply flew too low? He would end with the same fate of drowning in the sea, but it would provide a much different perspective. This would be a lesson in under-confidence instead of hubris.

Not only does this myth teach us of the dangers of arrogance, but we could argue that there is also a lesson of the dangers of timidity.

When investing, we are constantly dealing with our inner Icarus. How much risk is too much? How much is not enough?. How much risk is too much? How much is not enough?

In order to effectively assess risks, we need to do the same analysis on financial markets as we do with your personal risk tolerances.

Which leads the the obvious question…are financial markets closer to the sun or the sea right now?

Let’s look at three primary factors in today’s market that could melt the stock market’s wings:

  1. Valuations
  2. Rising Bond Yields
  3. Inflation
Valuations

One of the least debated aspect of the stock market today is whether stocks are overvalued or not. (Spoiler Alert…they are). By all historical standards, valuations are elevated. And in many stocks, outrageously so.

The most common valuation metric to analyze is the P/E ratio. This simply calculates the Price of the S&P 500 per share (P) and divides it by the total earnings per share over the past 12 months (E). So if the price of the S&P is 3000, and the earnings are 100, the P/E ratio is 30.

For over a century, this ratio oscillated between a low of 8 and a high of roughly 23. Currently, the PE ratio is almost 40.

With a reading this high, you would assume that the market should be on the cusp of a large decline, right?

But a closer look shows something different. A strange thing started to happen in the 1980s and ’90s. Valuations appear to have gone through a regime shift higher.

The chart below shows the trailing 12-month P/E ratio for the S&P 500 since the early 1870’s. (Data was extrapolated prior to the S&P 500 inception in 1957.)

For over 100 years, P/E ratios oscillated between very predictable levels of 8 to 23. During the early and mid-90’s, things started to shift higher.

Since 1990, it had a low of just below 15 and a high of over 80! Technically, the P/E ratio was not able to be calculated, because earnings were negative in the first quarter of 2009. So in actuality it was like much, much higher than 80.

We’ve been conditioned to believe that stocks are over-valued if the P/E ratio is over 20 or so. Pundits on CNBC say that all the time. After all, the people in charge of the financial media and the large investment corporations learned about stocks and investing when there was no reason to question the validity of this predictable valuation range.

But a closer look suggests this regime shift may not be a temporary phenomenon. After all, 30 years isn’t exactly a short amount of time.

But more importantly than the actual levels of the P/E ratio is the timing of when this ratio was elevated. The high points in valuations did not occur at tops. They occurred near a LOW point in the market.

Going back to the late 1800’s, nearly every time P/E ratios peaked were very poor times to sell stocks. The 1890’s, early 1920’s, mid-30’s, early 60’s, early 90’s, 2002, 2009 were very bad times to sell your stocks. Bull markets had years to run before prices ultimately fell.

Let’s take a closer look at this phenomenon. The next chart, courtesy of Bloomberg, supports this thesis that high valuations may not be as much of a warning sign as well. It shows the P/E ratio plotted against earnings-per-share for the S&P 500 since the mid 1990’s.

There have been four major spike in valuations since the mid-90’s. Three of these four times happened at a market low, not a market high. Granted, these are only a handful of data points, but it is still valuable information nonetheless.

Another interesting thing to note on this chart is that P/E ratios actually declined during the bull market from 2003 to 2007.

Maybe that is because valuations were SO extreme in 1999 that they could only go down. Makes sense. But it also suggests that levels once considered “expensive” from a valuation standpoint are more opinions instead of facts.

Instead of arguing that high valuations means that markets are near a peak, one could argue that the data supports exactly the opposite conclusion…that with the spike in valuations over the past year, a bull market may just be beginning.

But this conclusion just doesn’t feel right. Maybe it’s because we’ve been told for so long that these P/E levels are expensive. Maybe it’s simply because stocks ARE expensive right now. Either way, it’s tough to argue that using this ratio as a major part of a decision to buy or sell isn’t supported by the historical data

Which leads to the next logical question…why are valuations so high?

There are many theories. One is that low interest rates support higher valuations. That makes some sense if you factor in a low cost of capital. Another theory is that the easy money policy from global central banks have caused stocks to be the only investment in town that can make any real returns.

Those are both valid. However, the primary reason we are seeing the actual P/E levels in the S&P 500 increase is the massive increase in technology exposure in the S&P 500 over the past 30 years.

Currently, tech makes up 27% of the index. This doesn’t even include companies like Amazon, Facebook or Google, which are not considered a part of the “tech” sector. (Amazon is in the Consumer Discretionary sector, while Facebook and Google are in the Communications sector). Depending on how loosely you define “tech”, you could get 40-50% of the S&P that could be categorized as “technology”.

Tech companies have very high profit margins. So as tech becomes a larger portion of the overall market, net profit margins for the market as a whole increase.

This is a very clear trend. In fact, since the early 90’s, profit margins have nearly tripled, as shown on the chart below from Goldman Sachs.

The other thing to note on this chart is that the decline in profit margins that occurred during last year’s COVID-crash were nearly identical to the declines that accompanied the recessions and bear markets of 2001 and 2008.

Higher margins don’t just mean an increase in profits. They result in an increase in value for the companies involved.

Let’s say you were going to buy a company that makes breakfast tacos. One company makes $0.20 per taco, and the other makes $1.50 per taco. Assuming the tacos are relatively similar in quality and each company sells similar quantities, you would buy the company that makes more money off of each taco they sell. You would be willing to pay a higher price for that taco company as well, because your payback of invested capital will happen more quickly from the excess profits.

And if you could borrow money at very low interest rates, you could probably pay even more for that taco company.

That’s the other factor with the higher valuation regime. Interest rates have steadily moved lower over the past 40 years. (We’ll talk more about that below.)

This analysis doesn’t even get into the vast numbers of companies that don’t even have earnings. Tesla fell into this category for years.

But there has to be a limit to everything. No stock keeps going higher…it ALWAYS works in cycles. As legendary investor Howards Markes says, “Trees don’t grow to the sky.”

But, as the next chart shows, trees can grow to be pretty damn tall. The price levels of the stocks that aren’t making money is flat-out ridiculous. In what may end up being one of the most interesting charts of the year, let’s look at the Goldman Sachs Non-Profitable Tech Index, courtesy of Jim Bianco of Bianco Research.

This chart measures the performance of publicly traded companies who don’t have profits. Basically they lose money. The price has skyrocketed since the COVID lows a year ago.

This index was overvalued at 200. It went to 400. Heck, it was overvalued at 100 if you look at traditional valuation metrics.

But it kept going higher.

Analyzing this chart is not an exercise in valuation analysis. This is an exercise in sentiment analysis. No valuation level is too high, because they are ALL too high. But that doesn’t mean the price will fall.

These investors are not looking at valuations. And ultimately a stock price is what someone else will pay for it, not what some formula thinks it should be worth.

Many of you reading this may disagree with the following conclusion, but P/E ratios are simply NOT a useful tool to help identify the future direction of the market.

The data just doesn’t support it. Maybe the past 30 years are an anomaly, and P/E’s will again provide actionable insights for investing decisions, but not now. And maybe not in the near future either.

In fact, not only do valuations not provide much benefit when making investment decisions, they don’t even provide that much information about the current state of the market in general. We’re sure that would go over well on CNBC.

What really happens when you analyze valuations is that you are trying to make a prediction about someone’s REACTION to the valuation. It’s not the valuation itself that could drive the stock price, it’s other people’s perception of the valuation relative to current market prices that matter.

So essentially valuation analysis is trying to predict stock prices by predicting company earnings and then predicting people’s reaction to what the changes in price may be. You’re multiple steps removed from actual stock price analysis, which is all that matters at the end of the day.

As with all things, the current poor usefulness of valuation metrics is probably temporary. So while it does not provide much useful information now (and hasn’t for at least the past 30 years), it will likely provide excellent information as soon as everyone decides it doesn’t work. Like all things, it will likely prove to be cyclical. So we’ll continue to watch them.

Back to Icarus, it feels like valuations this high should mean we are pretty close to the sun. But the data does not support being very confident in that, especially with a 40% market crash only 12 months ago.

What it does mean is that we should expect anything. If we saw a valuation spike last year that marked a major low, then prices likely move higher for quite a while longer. But if valuation measurements start to become important again, then caution is warranted.

Yes, that’s a cop out. But it’s true. It’s okay to own stocks right now. Just use stop losses to keep your losses small, and use trailing stops on the profitable stocks.

Rising Interest Rates

The next thing we hear quite often is that higher interest rates may “pop” the equity bubble.

Not much analysis needed here. The data simply doesn’t support that theory.

The chart below, from LPL Research, shows extended periods of time when the 10-year US Treasury yield rose.

There were 14 periods since 1962 when this happened. 11 of those 14 times resulted in higher stock prices. And the other three were down, but all less than 20% during the same time period.

It seems the same conclusion about valuations can be applied to higher interest rates…it’s just not a good indicator of increased risk. Like the valuation spikes, one could argue that rising rates are bullish for stocks. Maybe it’s going to matter, but there is not a statistical reason why we should ACT on the potential for higher rates. At least not when it comes to stock investing.

Bond investing is a totally different story. Rising rates mean that bond prices are falling. So if there is any kind of investment action to take, it’s to be very cautious about owning bonds right now.

Extremely low interest rates rising to more normal levels does not suggest markets are too near the sun to melt any wings yet.

Inflation

We’re going to take a deeper dive into inflation pressures in the near future, so we’ll only do a high-level overview here.

Outside of the Federal Reserve, inflation will most likely be the biggest single driver of markets in the coming years.

In the United States, markets haven’t had to deal with inflation in over 40 years. There has been a steady decline in both interest rates and inflation since the early 80’s. That has allowed assets of all types (stocks, bonds, real estate, commodities, etc.) to experience a tailwind for rising prices.

But contrary to what many people think, inflation isn’t likely to just show up on your driveway unannounced like Cousin Eddie in Christmas Vacation.

After 40 years of declining/low inflation, it won’t suddenly jump to 10% per year. There will be a transition.

So we can think about the coming inflation in two phases:

  1. The Transition to Higher Inflation
  2. High Inflation

The transition phase could take years, maybe even a decade. Right now, we are likely in the early stages of the transition phase.

The most common investment consideration of the High Inflation phase will be the massive separation between winners and losers in the markets. The transition phase will be the gradual split between these two camps.

What this means is that there will be areas of the markets that will provide awful returns. The easiest one to predict is the bond market.

Bonds and inflation are angry neighbors. They hate each other. Bonds hate inflation, and inflation hates bonds right back. . When the cost of goods and services rise, a fixed rate investment loses both nominal and real value. Even if you have a nice little muni bond paying 2% tax free, you still lose money in the form of purchasing power over time as inflation rates increase. If you have a bond fund, you get both small yields and declining value, with no maturity date to get your money back.

The other easy place to identify as poor investment options are companies that don’t have pricing power, or whose valuations were elevated because of a low interest rate environment. High growth companies, including many tech names, are included in this group.

So right as we think that valuations don’t matter, inflation could be the very spark that makes them matter once again.

As we said, we will dig more into the inflationary winners and losers in the near future.

But it’s not just assets or companies that will be affected in a rising inflationary world.

From an overall investment standpoint, many of the core tenants of today’s investment world will be upended in the coming environment:

  1. Broadly allocated portfolios will suffer.
  2. Index investing will lose it’s appeal with investors.
  3. An increasing dispersion in returns will favor active over passive investing.

In an inflationary environment, portfolios must become more focused. If you invest 40% of your portfolio in bonds, expect negative returns on 40% of your assets for a very long time into the future.

Likewise, if you invest in index funds (many of which have 40% in tech stocks), expect mediocre returns at best. With such high exposure in tech and growth stocks, index funds will have massive exposure to underperforming companies with high valuations and little pricing power.

As we discussed above, profit margins have been expanding for a long time now on the back of the technology revolution. One of the negative potential effects of inflation is the potential for it to reduce margins substantially.

Inflation is definitely a factor that could melt the market’s wings. When that starts to affect the broad stock indexes in very unclear.

But if we break apart the market into different subsets based on their potential impact from inflation, we then start to realize that certain assets are poised to do very well over the coming decade, while others are likely to struggle mightily.

In the very near term, the Federal Reserve IS the sun. Massive monetary stimulus, combined with massive direct stimulus into the economy in the form of direct payments to individuals, is THE recipe for inflation. And is THE primary source of heat that could make the market soar or melt its wings.

If for some reason inflation does not show up in the coming years, then all theories about inflation are dead. If it does not happen, then we will likely see a massive deflationary shock. This is not a good scenario for anything or anyone.

But in the meantime, it sure does appear that inflationary pressures are building.

In our opinion, being nimble is always a good thing when investing. But as we transition into a phase that separates winners from losers, it graduates from being a “good” thing to have to becoming a “necessary” part of any investment strategy.

Bottom line, there is sufficient data to suggest that the market is closer to the sun that to the sea right now. But not enough data to warrant an intentional shift to a lower risk portfolio.

Let us heed the advice of Daedalus, on both fronts. Don’t be too risky without proper risk controls, but also realize that this environment may still be conducive to excellent returns. So don’t fly too close to the sea either.

Invest wisely!

Disclaimer This presentation is for informational purposes only. All opinions and estimates constitute our judgment as of the date of this communication and are subject to change without notice. > Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.

Ain’t it Funny how Falling Feels like Flying

The GameStop saga represents an investment fervor that has gripped the media and markets over the past few weeks. What really happened, and what are the takeaways from yet another strange environment we find ourselves in?

“Ain’t it funny how falling feels like flying, for a little while.”

-Jeff Bridges in the movie “Crazy Heart”

In the movie Crazy Heart, there’s a song called “Ain’t it Funny how Falling Feels Like Flying, for a Little While”. The lead character in the movie is played by Jeff Bridges, who writes songs and scrapes by a meager living most of his adult life.

This song represents the musician’s attitude that just when he thinks he is on his way to commercial success, is only dealt with more and more setbacks in his career and personal life.

As soon as we think the craziness emitting from 2020 has passed, another string of strange circumstances emerges.

This time it involved a set of poorly run companies struggling to survive, an army of individual traders on a social media app, and a small group of heavy-weight institutional investment firms, all wrapped up in an investment frenzy.

There have only been a few times that we have received questions as consistently and repeatedly about a single topic in the markets as we have had with GameStop. It obviously happened with the COVID crash last year, and happened with Bitcoin a few years ago, but not since the Flash Crash in 2010 or even back to the financial crisis have we seen and heard such intense media focus as we have with this topic over the past couple of weeks.

Virtually every one of our circle of friends was talking about it at some point last week. Golfers in clubhouses were overheard chattering about it. High schoolers at lunch talked about the gamification of the stock market. Every area of the social media and online sphere was discussing some aspect of what was occurring. Was it time to buy? Should you buy put options? What happened? Is this normal? Were all questions we were hearing and fielding last week.

So what is this mess about GameStop really all about?

Background

GameStop is a retail company that sells physical video games in the form of DVDs. It is a very poorly run company that has been 10 years late to everything. They are the Blockbuster video of the gaming world. GameStop tried to rebrand themselves as selling “collectibles” and virtual reality devices. But they are selling things that people no longer need. Games can now be downloaded instantly.

There are many people, including a few large hedge funds, who think it will go bankrupt. They are probably right. So they have shorted the stock, betting that the stock price will go down in value, possibly to zero.

Shorting a stock is like borrowing someone’s car and selling it. Then before the owner of the car asks for it back, you try to buy the same exact car at a cheaper price. Voila, you made money. Your profit is the difference between what you sold the car at initially, minus the price of the replacement car plus some minor carrying costs.

This is what happens when you short a stock. You borrow shares, sell it at today’s market price, and hope the price falls before you have to buy it back.

This works great if the replacement car is cheaper than the original one you sold. However, if the price of the car goes up, you now have to buy a higher priced car to replace it. Congratulations, you are now losing money.

With stocks, unlike cars, prices tend to move higher over time. Shorting stocks is very difficult and requires a great amount of luck skill to be good at doing it.

What Happened?

Over the past two weeks, GameStop (ticker: GME) stock has been amazingly volatile.

The media over the past couple of weeks has been calling this a “short squeeze”. Sticking with our car analogy, a short squeeze is like having hundreds of people in a small town borrow the same kind of car, and they all sold it to the same dealer (these people “shorted” the car). Then when the car dealer starts to have people wanting to buy that car back, he starts to raise the price. Demand is now out-pacing supply. That dealer is “squeezing” the buyer to get more money out of him.

To make matters worse, with GameStop, more people had sold cars than there were cars in existence. 140% of the totals shares outstanding were short. So there was literally no inventory of shares (cars) that could be bought back anywhere near the market price from a couple weeks ago.

That’s okay if no one wants to buy that car. Maybe it’s an ugly car that breaks down all the time. It probably is worthless, and who in their right mind would want to buy it? But in GameStop’s case, a bunch of people decided they were all going to start buying ugly cars that broke down all the time. The people who borrowed and sold these cars had to scramble to find cars to buy and deliver back to the original owner.

In the stock market, there is not just one buyer of shares. There are millions of different buyers.

But a coordinated effort took place in GameStop and a handful of other stocks that sparked a buying frenzy. A group of young people on a social media platform named Reddit banded together to stage a “short attack”. They recognized that there was an imbalance in the amount of shares that were “short” GME stock. They were trying to “squeeze” the hedge funds that were irresponsibly short.

These hedge funds were the ones who had borrowed and sold the ugly cars. And they were incredibly irresponsible how many they sold.

A key feature of selling a stock short is that when it goes up in price, it becomes a larger position in your portfolio. If you buy a stock for $100,000 and it goes down 50%, then your exposure to that stock falls. It was worth $100,000, but now it is only worth $50,000. Not fun, but technically your risk reduces as it falls.

When shorting a stock, your risk exposure increases. If you short a stock with $100,000, if it goes up 50%, you now have to pay $150,000 to buy it back. It has become a larger risk in your portfolio.

Imagine what happens if a stock goes from $16 to $480?

One key theme over the past few weeks is the idea among these young traders that buying GameStop stock was a form of protest. We have seen protests take many forms over the years. But this is a new one.

The thing is, it worked. They were flying. For a little while.

Let’s take a look at GME stock over the past month.

In the span of a couple weeks, GME stock rose from $16/share on January 12th, to over $480/share on January 28th. This is a staggering 3,000% return.

Some of these young traders were proudly showing off their gains. One of the ringleaders, 34-year-old Keith Gill (pictured below), showed daily snapshots of his trading portfolio. At one point, it showed a balance over $50,000,000. Holy cow, talk about flying.

It wasn’t just Mr. Gill who was showing off. Many people on social media, from the marketing genius behind Barstool Sports, Dave Portnoy, to tech entrepreneur and Dallas Mavericks’ owner Mark Cuban jumped on the bandwagon. Most likely in attempts to enhance their popularity among this “Reddit” crowd.

Many people were advocating to buy GameStop stock. Many others said to “Hold the Line” and not sell the stock. They were bankrupting a hedge fund. Hear me roar!

However, there are a few problems. First, a stock that go up 3,000% in a couple weeks probably won’t stay at that price very long. Anyone who has been in the investing world knows that. In the least surprising development of all, the stock has collapsed back down to the $60s, as seen on the GME chart above.

Another problem is that you aren’t supposed to give investing advice without the proper licensing. A public mention on social media to buy or hold a stock is technically a recommendation. Doing so without a license is illegal. Oops.

What is even wackier is that Mr. Gill himself is actually registered to recommend securities with an insurance firm called MassMutual. Because of this, he is now under investigation by the SEC and may have to testify in front of Congress. Read more about that part of this crazy story at the NYTimes HERE.

Of course, now that the stock has cratered, likely with further to fall, Mr. Gill has not shared a screenshot of his winnings.

These traders now realize they are falling.

But there is much more to this story than just a group of small traders banning together to “stick it to the man” in protest. So let’s instead focus on some of the things that the media is not talking about.

Stop Squeezing my Gamma

First of all, short squeezes happen all the time.

In fact, the alt-news website ZeroHedge has been tracking short squeezes back to at least 2013. And it surely has been happening much longer than that. The next chart below, from ZeroHedge, shows that short squeezes can perform very well. Since October, the most shorted stocks are up over 3x the Russell 3000.

The stocks that were the most shorted are companies that are likely in the most financial peril. When these companies outperform the broader market handily on a regular basis, then it’s probably safe to say that there is something way beyond fundamentals driving these price trends.

Back to the earlier chart of GME. Once the price of GME started to move higher, the short squeeze added fuel to the fire. Those who are short the stock have to “cover” their positions (buy back the car they sold), buy buying back those shares in the open market.

A short squeeze in many ways is a self-fulfilling prophecy. The higher the price goes, the more shorts need to cover. Rising prices cause more short covering, until eventually existing holders decide prices have swung too high and decide to sell, helping stop the squeeze.

But the real gasoline that was thrown on the stock was likely what’s referred to as a “gamma squeeze”.  A gamma squeeze is more of a function of how markets work than anything to do specifically with GameStop stock. It has to do with the options market, which is like the stock market on steroids.

An option is an investment vehicle where investors buy or sell a stock at an agreed upon price and date in the future. Instead of selling that car immediately, you come to an agreement that by next week you will sell it as long as it is above a certain price.

Prices of options change in value daily, and typically move in a much larger percentage than the price of the underlying stock.

One way to measure how quickly the price of these options change is called “Gamma”. It is a term used to describe the rate of change of the price of the option compared to the rate of change in the price of its underlying stock. A gamma squeeze is a necessary by-product of having liquidity in an options market with speculators and hedgers.

Generally, a higher gamma results in more hedging that needs to occur by the writer of that option. As volatility increases, so does an option’s gamma. Gamma is what tells the option seller how much of a stock he needs to buy to hedge his position and in GameStop’s case, Gamma was getting higher and higher and hedgers needed to hedge with more and more GameStop stock.

The real takeaway from a GameStop perspective is that all of this had very little to do with its underlying business, except for the fact there were a lot of shorts in the stock.

But that is rather normal on Wall Street, and it is far from a “crisis” as some have been touting. Anyone that has been in the markets long enough knows that these kinds of things happen all of the time, just not to this extreme.

Both short squeezes and gamma squeezes are primarily driven by a stock’s price, not its fundamentals and is a result of its price rising faster than initial risk management expected. Prices rising quickly could be the giveaway that one of these squeezes is occurring.

What is also especially different with GameStop is who was at the epicenter of the trading tsunami.

My Name is Robinhood and I’m Here to Help

Robinhood is an online trading platform directed at younger investors. It is trying to make investing fun by looking and feeling much like a video game.

Most trading is done via an app on your phone. When someone makes a trade through this app, it looks similar to winning on a slot machine. Bells ring, digital confetti falls across your phone’s screen, and the brain gets a rush of cortisol as a reward. All by design.

The Robinhood app has exploded in popularity. Millions of investors, mostly younger, have used it to start investing. That’s a great thing.

Robinhood’s biggest selling point to these younger investors is that there are no fees. Well, if something is free, you are probably the product. That is what is happening at Robinhood.

The primary source of revenue for Robinhood is that they sell order flow to large firms. The biggest buyer is Citadel.

Citadel is a behemoth in the trading world. By purchasing order flow from Robinhood, they are purchasing information. They know what stock is being traded and at what price. They claim that they use this information to get the individual investor the best possible price on the stock order they just placed.

But in actuality, they do what is called “front-running”. Here’s an example.

A Robinhood investor wants to buy 100 shares of Apple stock at $134 per share. They get on their app, enter the order, and revel in the digital confetti. Because Citadel paid for this information, they know that there is an order to buy 100 shares of a stock at $134/share before the trade is actually executed.  Citadel then goes out and buys Apple for $133.9999 and sells it to this investor for $134.00. The investor gets the price they wanted, but Citadel just made a fraction of a penny on the trade.

Repeat this millions of times each day and you have Citadel’s business model. And Robinhood is not the only firm from which they purchase this order flow.

In the real world, front-running is illegal. At IronBridge, we are required by the SEC to review brokerage statements to see if any an employee is buying a stock before we buy it for clients. Because it is illegal.

Why can Citadel do that? Good question. The SEC has been trying to figure out exactly what they are doing, and have not been successful. Citadel did, however, sue the SEC to try to keep what they are doing private.  Citadel has felt like it has been flying. Will they eventually fall?

One thing is for sure, the Reddit traders sure want them to. In the middle of the mania last week, Robinhood halted trading in GME.

This was not an attempt by the “suits” to screw the little guy. This was a result of Robinhood’s own risk management needs as regulated by the SEC.

But it is understandable that the Robinhood crowd is up in arms. In the traditional story, Robin Hood steals from the rich and gives to the poor. The younger traders feel like the opposite has happened. Once they started to really make a lot of money, they genuinely feel they were cut off from trading. The “rich” stepped in and stole from them.

But Robinhood may not be as big a culprit here as claimed. Yes, they do sell information about its users to big hedge funds and yes, they do sell information that allows those hedge funds to front run their clients’ purchases. But that’s always been the case. After all, “if you don’t pay for the product, you are the product”. Robinhood has been doing that from day one.  (Whether it should be legal or not is a different story.)

What really happened is that as the accounts in Robinhood got larger and larger, Robinhood’s capital base couldn’t support it. Risk Management stepped in and a decision was made to both: 1) lessen the potential volatility – how to do that? You lessen the trading in volatile stocks and then ultimately 2) Raise billions of $$$s of outside capital in order to shore up Robinhood’s balance sheet and increase their cash deposits.

Robinhood takes on a slight amount of credit risk due two what is called “T+2 Settlement. This antiquated system says that if you buy a stock, it doesn’t “settle” in your account for two days. If you make a trade and immediately withdraw funds, the brokerage firm has to pony up the money for that trade. Granted, they will go after you and get their money back, but they still have risk between the trade date and settlement date.

This is not so different from normal banks and the entire fractional reserve banking system. Banks must hold a percentage of their clients’ accounts assets in reserve, and so too must a Robinhood and other brokerages. As client accounts grow, so too must the Robinhood Capital base.

Robinhood actually provided a great blog post that helps summarize how the system works. If you want to be mad at someone for inhibiting the rights of traders, be mad at the the risk management department of Robinhood (you live by the sword you die by the sword), or be upset with the traders themselves for choosing a less financially stable firm, like Robin Hood, for doing their trading.

Or go even higher and get upset with the clearinghouses and ultimately the Depository Trust Clearing Corporation. Is Robinhood completely innocent? Probably not. But it doesn’t seem that Robinhood is as evil as the Reddit crowd has portrayed them. They operate in a much more regulated world than the Robinhooders probably realized.

Bloomberg explains the back-office part of it pretty well in this piece, and the Observer supports Robinhood’s decision in this piece.

Now did the hedge funds that were getting hosed make a few calls to some friends? Our guess would be yes. In a perfect world we will learn more about that come mid-February when the parties involved have hearings on Capital Hill.

What are the Takeaways?

This is a complicated issue, but there are some very clear takeaways.

Short Selling is not a bad thing. Maybe there should be some limits to it, but any structural problems in our markets today are not due to short sellers. The hedge funds who lost money got what they deserved by not appropriately managing risk.

T+2 Settlement is outdated and should be changed. There is no way in today’s technology environment it should take two days for cash to exchange hands when a stock is bought or sold.

Don’t get over your skis. Markets are complex, and if you don’t know what you are doing you probably shouldn’t be doing it. You can only stay lucky for so long.

Markets are not efficient. Spoiler alert…they never have been. Things like GameStop happen every day. Just on a much smaller scale. The Fed printing gobs of money only serves to exacerbate it.

There are regulatory loop holes that favor the well connected. We are already starting to hear how there should be increased regulation by the politicians. Guess what? They are the ones who created these rules in the first place. Complex systems like global financial markets don’t have sound-bite solutions to their problems. It’s just not that easy.

Perhaps the single largest takeaway from this saga is this: The GameStop saga is a reflection of the speculative fervor that is gripping the financial markets.

This didn’t happen last March when markets were collapsing. This occurred after a massive rally in the markets. This fervor has permeated the fringes of the financial markets. It is happening in these Reddit stocks like GameStop. It is happening in assets like Bitcoin. Heck, it is even happening in residential real estate.

This is an environment where anything can happen. It is reminiscent of the late 1990’s. This same type of fervor took hold in the fringes of the markets in stocks like Pets.com. Just take a look at the cover of Fortune magazine from October of 1999.

The Nasdaq rose over 100% in the 6 months after this magazine cover was published. And it could have been published today.

The fervor in smaller internet stocks in the late 90’s eventually made its way into the broad markets and formed a massive bubble of epic proportions.

Will that happen today? That kind of flying would be pretty fun for a little while, wouldn’t it? But who knows if it will happen or not. We prefer boring markets. But we don’t get what we prefer. As our kids say, “You get what you get, so don’t throw a fit”.

Actually, there is more wisdom in that phrase than we would like to admit. (Being the highbrow, stuffy, intellectual types that we are.) The key is to not get emotional. The Reddit crowd got emotional. The hedge funds got emotional. The social media personalities got emotional. The politicians are getting emotional. They all have let their emotions control their actions, and they ultimately paid (or will pay) the price. You cannot do that when investing.

Making money is fun. But don’t get caught up feeling like you’re flying when you may about to be falling.

Invest wisely!

Disclaimer This presentation is for informational purposes only. All opinions and estimates constitute our judgment as of the date of this communication and are subject to change without notice. > Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.

Twin Risks: Valuations and the Fed

As we enter 2021, we turn our focus to things that could change the current bullish environment. Two main risks may emerge as the market continues its push higher: Valuations and the Fed.

“Life is a cycle, always in motion, if good times have moved on, so will times of trouble.”

-Indian Proverb

What a year.

And we’re only 8 days into it.

We read a meme online this week that said, “I tried the 7-day free trial for 2021, and I’d like to cancel it please.”

2020 was quite the year too. Just when we thought it was in the rear-view mirror, events remind us that the new year is more of a mental construct than any kind of actual barrier or turning point.

What may happen in 2021? How long can this bullish market environment last? What should we be watching for?

2020 Review

First, let’s briefly review the chaotic year of 2020.

A year ago, if someone told us that there would be a global pandemic that killed millions of people worldwide, GDP fell by a whopping 33% at one point, there were riots across the country, the presidential election was contested, and a mob stormed the US Capitol, what do we think the markets would have done?

Obviously, the majority of those surveyed would almost all say that markets were in total chaos. We would likely have predicted that market would be 40-50% lower, if not more.

But what happened?

  • The S&P 500 rose 18%.
  • The Nasdaq rose an amazing 43%.
  • The Dow Jones rose 9%.
  • Bonds rose over 7%.

These are not returns we would normally associate with a chaotic environment.

Which brings up an interesting question: What if the COVID market crash in March was just an exogenous anomaly?

At the time, it all seemed very logical. The forced shut down of the US and global economy had a real, tangible effect on markets. The subsequent rally, fueled by central banks across the globe, lifted financial markets, while having very little impact on those truly affected by the virus.

Generally speaking, markets have both internal and external influences. External, or exogenous, influences include things like COVID, terrorist attacks, assassinations, etc. While internal, or endogenous, influences are things within the market structure that affect prices, such as the Fed and the financialization of real estate prior to 2008.

Most investors believe that external factors have the most influence on asset prices. But throughout history, external events tend to have only fleeting impacts on markets. COVID may very well end up being another one of these exogenous events.

Let’s look at a chart to illustrate the seemingly temporary impact of COVID on asset prices.

The first chart below is the S&P 500 Index since mid-2018. The big spike downward is what we refer to as the COVID crash. The second chart simply removes the three months around this crash.

S&P 500 Index during and after the COVID crash of 2020-2021
S&P 500 Index without the price drop in the COVID crash

By removing the panicked, crash environment in March and April, the market appears to have simply gotten back on track to the trend it had before COVID-19 showed up.

Of course, we cannot simply remove parts of history that we don’t like. There is valuable information in the data removed from the second chart that helps give context to the current environment.

However, COVID absolutely classifies as an external influence to markets. This crash was not the result of a build-up of excesses. It was not the result of the financial sector being massively over leveraged to real estate like in 2008. It was not the result of tech stocks being massively overvalued when the Nasdaq doubled in 3 months to end the tech bubble.

The COVID crash is frankly a textbook exogenous event. It was unexpected and wreaked havoc, but it will likely be temporary. If the market is assuming that it is temporary, it makes sense that it is looking beyond the next few months.

The more important thing that the the 2020 crash did was it amplified two major risks in 2021 and beyond: valuation risks and Fed liquidity risks.

Valuation Risks

By any measurement, valuations on the equity markets are extremely high today.

There are multiple ways to measure valuations in the stock market:

  • Price to Earnings (P/E) Ratio
  • Price to Sales Ratio
  • Price to Book Value
  • Price to Earnings Yield

Today, every one of these are at or near all-time highs. Or at least they are higher than 98% of the readings that have ever occured.

Let’s look at the most common measure of valuation in stocks, the P/E ratio. This ratio measures the price of a stock (P) to the earnings per share (E) of a particular company.

The chart below shows this ratio for the broad market since 1870.

S&P 500 Index P/E ratio since 1870

With a current reading of 38.35, it is higher than only two other time in history.

One might suggest that it would be a good opportunity to sell based on this overvaluation.

We disagree. Valuations are an excellent way to view the potential risks in markets, but they are a terrible tool to make a buy or sell decision on.

Prior to the year 2000, valuations ranged from a low of 5 to a high of 22. If someone used the P/E ratio to make a buy or sell decision, they would have sold in the late ’80s or early 90’s, and would have missed an entire DECADE of returns, as shown the next chart below.

S&P 500 Index P/E Ratio with higher and lower bounds since 1870. A breakout of the high end of this range occurred in the 1990's.

Selling at other times when valuations were extreme were also not great times to sell. Every time the market reached the upper dotted line in the chart above (the mid-1890’s, early 1920’s, late 1930’s, late 1940’s) all resulted in poor times to sell. It resulted in tremendous missed opportunities. And if you waited until valuations became extreme to the downside, you missed decades of investment opportunity.So what should we do? Just ignore valuations altogether?

Not necessarily.

Valuations by themselves are fairly useless. And by “fairly” we mean “very”. A stock can remained undervalued for years. And a stock can also remain overvalued for years.

But valuations can provide context to help determine where we might be in an investment cycle.

For periods with higher valuations to become more “normal”, it requires either prices to fall or earnings to rise.

After the last two periods of overvaluation in 2000 and 2007, prices fell. Of course, earnings also fell since the economy was in a massive recession each time. But prices fell fast than earnings, so the P/E ratio also fell.

But this is not always the case.

Following the overvaluation in the early 1960’s, prices did not fall. They went sideways for nearly 20 years. Earnings eventually caught up to prices, and P/E ratios fell as the “P” stayed the same and the “E” rose.

So just because valuations are high doesn’t mean prices should fall. It means that we should be alert for a change in trend, but it does not mean that we should flat out sell.

When looking at today’s landscape, extreme valuations can be seen everywhere. Tesla is a prime example.

Tesla stock rose more than 700% in 2020. It made Elon Musk the richest man in the world yesterday. In fact, it has risen over 1,000% from the March lows.

TSLA stock price

So far in 2021, the total value of Tesla stock has increased more than the total value of GM and Ford combined. It has not achieved a value more than GM and Ford combined, it has increased more than the two combined. And that’s only this week.

People thought it would fall at $200 per share. And at $400. And at $600. Rinse and repeat. At some point they may be right. But no one knows from what level the price will ultimately reverse and move lower or move sideways.

But we don’t need to know when that may happen. We only need to know that these are indications of frothiness. They are not indications that we should massively raise cash immediately.

They are indications, however, that you should have stop-losses and a pre-defined exit strategy.

And those stop-losses should be rising in conjunction with the prices each of your investments. High valuations are indicative of a late cycle environment, and these environments have the potential for danger.

Anything can pop the bubble of high valuations. But it is usually something from within the market itself that ushers in the next bear market. COVID tried to pop the bubble, but appears to have failed. In fact, valuations seem to have benefitted from COVID. Go figure.

So what could cause the market to fall, and valuations get back to normal levels?

Ironically, it is the same thing that could keep valuations high for an extended period of time.

The Fed.

We’ve talked about the Fed a LOT in this newsletter. And you should probably expect us to continue to talk about it.

Risks from the Fed

In our view, markets could continue to move higher for quite some time. But they also could turn lower tomorrow and begin a multi-year decline.

So here is our formal 2021 prediction: we have no idea what is going to happen.

For our clients and longer term readers, you’ve heard us say this before. It’s okay to not know what is going to happen. In fact, it is more dangerous to think you know the outcome when dealing with complex systems than it is to admit you don’t know and prepare for multiple outcomes. It simply depends on how the markets view the Fed’s ability to keep prices propped up.

For now, the market is resilient. The Fed is turning events that seemingly should startle the market into non-events that simply have no effect on prices whatsoever.

The best sign of a bull market is when prices rise in the face of bad news. We have that in spades right now.

However, we don’t know how long this will last. We do know that it will not go up in a straight line, that there will be volatility, and that at some point we will likely enter into a new phase of extended price declines. Worse than what we saw in the COVID crash.

But what would the Fed do to start the next down market?

First, the Fed could make a policy mistake. Markets are watching every move the Fed makes. Policy mistakes could include raising rates too fast, or providing guidance that is unexpected to the market. They could push too much money into the financial system and cause hyperinflation. They could intervene in currency markets and cause imbalances that cause ripples throughout the globe.

Second, a new Fed chair could emerge who causes uncertainty. The current Fed chairman, Jerome Powell, holds this position until 2022. President Biden may choose to reappoint Mr. Powell, but will likely appoint his own chairperson. He announced that former chairwoman Janet Yellen would be his Treasury Secretary, so it appears on the surface that he wants to keep the current policy of easy money around for a while.

Third, the market may simply come to the determination that enough is enough. Trillions of dollars of money printing will have consequences at some point. The further we go along the current path of obscene money printing, the more dire the future consequences in our opinion.

So at some point, we will need to take steps to preserve assets for our clients and have large allocations to cash and other non-stock assets. But that time is not now.

As we start 2021, the market continues the trend of 2020 and is moving higher in the face of bad news. At some point, maybe 2021 is opposite and moves lower on good news.

In the meantime, markets continue to make all-time highs, and the trend is higher. This trend should be respected until proven otherwise. It could remain higher for longer than any of us think possible.

Until then, we will continue to look for both opportunities and dangers, and adjust to whatever 2021 may bring.

Invest wisely!

Our clients have unique and meaningful goals.

We help clients achieve those goals through forward-thinking portfolios, principled advice, a deep understanding of financial markets, and an innovative fee structure.

Contact us for a Consultation.

Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.  Disclaimer This presentation is for informational purposes only. All opinions and estimates constitute our judgment as of the date of this communication and are subject to change without notice. > Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.

New Highs are Bullish

Stampede of Bulls signifying that New S&P 500 stock markets highs are bullish

November was one of the strongest months in market history. Various markets across the globe are pushing to new all-time highs. When conditions are bullish, we should expect bullish outcomes. In this month’s report, we look at an important investing lesson and identify the top two potential outcomes for markets in the coming months.

“If you change the way you look at things, the things you look at change.”

-Wayne Dyer

There are times when markets give investors very obvious lessons. The best investors listen when these time happen. The past month has been an excellent time to learn and improve on your investment process.

Prior to the election, the prevailing wisdom was that an uncertain or delayed election outcome would cause volatility in the markets. This makes complete sense. We live in a very polarized political climate. There have been countless riots this year. Many businesses boarded up their windows in anticipation of post-election violence. Tensions across the country were running very high.

Following the election, there was no clear winner. Vote counts were delayed. Accusations of fraud were everywhere. Legal challenges were obviously going to be made. This was the EXACT scenario that “should” cause markets to be extremely volatile.

What happened in the markets? The S&P 500 surged over 12% in 6 days. This happened before any election resolution and before any vaccine news. In fact, since the vaccine announcements, markets have gone sideways.

What is the lesson?

Stop trying to predict the markets.

Markets don’t always make sense to the casual observer. Heck, they don’t always make sense to the professional observer, ourselves included.

Predicting the future outcome of the markets, and gambling your hard-earned wealth on predicting extremely complex systems, is not a prudent use of your capital…both financial capital and mental capital.

It introduces too many negative consequences into your process. If you’re wrong, you become paralyzed. You thought markets should fall, but they rose dramatically. Or you thought markets should rise, and they fell dramatically.

So you’re left holding too much cash. Or you’re left holding stocks with big losses. Both have incredibly damaging effects on the psyche of the investor. You risk having one mistake carry over to your next decision. As they say in golf, don’t let one bad shot ruin your round.

We’ll dig deeper into this lesson next month by focusing on the effects that predictions have on the brain. But keep one lesson about predictions in mind…it’s not about getting it right all the time. It’s about probabilities. It’s about identifying the conditions that are present in markets, and whether those conditions provide good investment opportunities.

The best condition to identify and understand is price. This is what too many investors overlook. Which is strange because price is what matters most. Price is what makes an investment good or bad. Price is what affects your statement value. Price is what allows you to achieve your investment goals. Price is what pays. A good investment is one that goes up in price. So why focus on things that may or may not influence price?

We’re in a climate where price seems to be disconnected with reality. And that’s okay. It happens more often that we realize. It’s just SO obvious right now that it’s hard to ignore.

But price IS reality. A stock is worth what someone else will pay for it.

This is why we look at charts and discuss them in this publication. Charts are visual representations of the reality of the markets. We can disagree with them all we want, but that’s the reality.

So let’s focus on price and look at some charts.

New Highs are Bullish

A key part of the IronBridge investment process is the identification of trends. We don’t like to fight the market, and prefer investing with the wind at our backs. That means finding favorable trends and participating in them. And right now, there are favorable trends everywhere.

In the US, not only are large-cap stocks making new highs, but we’re seeing the more aggressive areas of the market make new highs as well. Mid-caps, small-caps and semiconductors made new all-time highs last week. Various international stock markets in Europe, Asia and South America are also making new highs.

The areas that were hit the hardest in the COVID crash, such as energy companies, banks, airlines and publicly traded restaurants are even participating in the move higher.

Let’s start by looking at the granddaddy of global markets, the S&P 500.

Following the COVID lows in late March, the S&P skyrocketed higher, almost unabated, through early September. But since the September high, markets have been choppy, with no real direction.

The first chart below shows this price action.

Following the September highs, there was no news at all that would cause the markets to pull back. But the S&P fell 10% in a few short weeks.

The choppiness continued with nearly three months of a sideways consolidation. This served to work off some of the excess bullishness that had built up from the March lows.

The surge around election day is an interesting one. As we mentioned above, markets rose 12% around the election. The high of that move actually came on the day that the Pfizer vaccine was announced. This came at the end of the move higher, not the beginning.

In fact, since the Pfizer news, we have had two other major developments in COVID, with the Moderna vaccine showing 94% efficacy, and the treatment that President Trump received while at Walter Reed hospital was also approved. Yet markets have gone sideways.

The markets seem to have anticipated the vaccine news. It has been public knowledge for quite some time that many vaccines were getting close to being available. If that is the case, then markets may also be looking past the obvious spike higher in cases we are currently witnessing across the country and the globe.

The markets also like a split government. There was no blue wave, and it seems that the US government under a President Biden may be a very centrist one. We wrote about this immediately after the election in our report “Gridlock is Good”, which you can read HERE.

Most importantly, the Fed is still very accommodative. They are scheduled to put another $3-4 Trillion into the financial markets in the coming months, and that should provide another tailwind to markets.

It’s not only the S&P that is breaking higher. Other notable indexes making new highs are shown in the next chart.

This chart shows the following indices moving clockwise from the top left: the S&P 500, the Dow Jones Industrial Average, the mid-cap S&P 400 Index and the small-cap Russell 2000 Index on the bottom left. The orange lines on the charts are the previous highs.

The first to make new highs was the S&P, which happened in September. This was primarily due to the heavy weighting of companies like Apple, Amazon and Microsoft in this index. Last week saw the remaining indices make new highs.

However, the most notable development is on the bottom two charts. These are weekly charts showing prices back to 2017.

Small-caps and mid-caps have both struggled to get above their price level from early 2018. These markets have gone sideways for almost three years.

When markets move sideways for long periods of time, there is usually substantial buying pressure when prices do finally break higher. This is precisely what we’ve seen happen in the past month. In fact, November was the strongest month EVER for small cap stocks…up nearly 20%. So much for volatility around the election.

No one predicted this kind of strength. It seems to have been quite the opposite. Most investment firms were predicting volatility, and rightfully so.

These are not signs of weakness. There is literally nothing more bullish than new highs. It is by definition the sign of an up-trend.

With the backdrop of strong price trends, a supportive Fed, and a potential light at the end of the COVID tunnel, what could go wrong?

Potential Outcomes

Again, price is what matters, not predictions. So while the backdrop appears very favorable, that does not mean that markets are without risk right now.

We view the current environment as having a binary outcome potential, where only two scenarios are likely.

We show these outcomes in the chart below.

While anything can happen, the first scenario seems most likely at this point.

Scenario #1: Melt Up

Despite the massive move higher since March, the conditions are present for what is called a melt-up. The tech bubble of the late 90’s is the best example of this environment. In this scenario, prices are not only dislocated from reality, the become more dislocated at an increasing rate.

A realistic target for this scenario is for the S&P 500 to get to the 4500 range. This would be close to a 30% return from here. There are scenarios where the market isn’t quite that strong, but there are also scenarios where the markets move even higher.

What could lead to this happening?

As we have said countless times over the past 6 months, the Fed is the most important factor in the markets right now. They are printing massive amounts of money that is making its way into the financial markets.

The primary risk to this scenario is that there is a change of policy at the Fed. This risk, however, may have been greatly diminished with the announcement today that President-Elect Biden will nominate former Fed-chair Janet Yellen as the Treasury Secretary.

This is a strong endorsement of the easy-money policies that the Fed has been implementing for years, and a clear signal that Biden wants to continue pumping liquidity into the system.

So it appears that the Fed won’t be an issue in the near term.

We then have to shift the focus to COVID. Cases are spiking, and Los Angeles just imposed another lock down. Will this happen on a more widespread basis?

Possibly, but the market is clearly signalling that it thinks the worst of the economic-related COVID issues could very well be behind us. What a wonderful thing to even consider.

This scenario is a fun environment if you own stocks. Melt-ups can provide amazing returns in short periods of time. It is a crushing environment if you’re sitting on too much cash, or even worse, if you’re trying to short the market.

While it appears to be a favorable backdrop for stocks, don’t ignore the downside risks either.

Scenario 2: Whipsaws

The other scenario that could play out would be a whipsaw market. Whipsaws occur when there is no real direction, and breakouts get reversed quickly. This results in a frustrating market that punishes a great number of people.

In this scenario, COVID is the likely culprit for market weakness. There could also be something completely different and unknown that causes it as well, but the logical reason would be continued economic hardships and deaths from this virus.

Markets need to reverse lower very soon in order for this scenario to play out.

This scenario would result in a few things happening:

  • First, the break to new all-time highs wouldn’t last. Markets would reverse course and move down below the 3550-3600 range on the chart above. Everyone who thought the breakout would continue would be mistaken.
  • Then, a quick move to the lower end of the range since September would occur. This could happen in a matter of weeks, if not faster.
  • The market would then break the lower end of the range, and get to the 3100 level, plus or minus.
  • The break lower would then be reversed, causing the markets to whipsaw around that low. This would cause everyone who thought we were headed to much lower markets to be mistaken, and prices would start to move substantially higher.

Ultimately this scenario puts the market at new all-time highs. We would just need one more bout of volatility to come to fruition first.

Of the two scenarios, our clients are currently positioned for scenario #1, and think this has the higher chance of happening. But we will not die on that hill, and are ready to make adjustments as necessary.

Bottom Line

Bottom line, the conditions are currently bullish. There has been a strong uptrend since the COVID lows, and these trends have been confirmed by multiple new highs.

In bullish environments, we should expect bullish outcomes.

If you have excess cash right now, you can put it to work. Just pay attention to your exits and have a defined risk management plan. As quickly as these environments rise, they can just as easily fall and erase all of their gains.

It appears that we have another window of opportunity in front of us. Take advantage of it. And if things change, don’t be afraid to adjust course.

Invest Wisely!

Gridlock is Good?

Markets across the globe surged today, despite election uncertainty. Just like in 2016, predictions about what would happen in the 2020 Presidential election were flat out wrong, as were market predictions for a market crash. It appears that gridlock, the Fed, and the potential for stimulus talks to resume are driving asset prices more than the uncertainty surrounding the election outcome.

“Gridlock is great. My motto is, ‘Don’t just do something. Stand there.'”

-William Safire, American author and New York Times political contributor

Given the fluid nature of the election results, we will be providing updates and context on portfolio positioning and analysis on how markets are responding.

We’ll keep these updates relatively brief, and we will likely be sending multiple reports over the coming days and weeks. As of this report, there has been no declared winner of the presidential election. However, it is becoming more likely that Biden could be the next President of the United States.

There are three main areas to discuss from yesterday’s election:

  1. Key Takeaways
  2. Market Analysis
  3. Portfolio Positioning

Let’s dive in.

Key Takeaways

Many people predicted that a contested election would throw the markets into turmoil, with numerous “experts” predicting a market crash if this happened.

There was no clear winner on Tuesday or Wednesday. Multiple states are still too close to call. Trump is threatening lawsuits and recounts. Neither side is budging. Results may not be known this week.

This is the exact scenario “experts” predicted would crash the markets.

Instead, markets were up substantially today.

Why?

Here is our initial reaction to the election results thus far:

  1. Gridlock is good. There was no blue wave as many people predicted. The market is interpreting this to mean that massive tax increases on individuals or businesses will likely not happen. Some tax changes should be expected, but they may not be as punitive as many initially feared.
  2. Predictions are Useless. In 2020, as they did in 2016, the “expert” pollsters had it massively wrong. So did the “expert” investment firms predicting market turmoil. Don’t use predictions as a basis for making political or investment decisions.
  3. Price is King. Prices are ultimately all that matter to your account values. Our job is to grow your portfolio during times of opportunity and reduce volatility during times of stress. Prices are telling us it is a favorable time to be holding risk assets.
  4. It’s Still all about the Fed. We’ve been saying this for months, the primary driver of market prices is liquidity from the Fed. The election uncertainty and delayed outcome did not change that.
  5. Expect Stimulus Talks to Resume. With the election behind us (sort of), the market will likely focus on continued COVID-related stimulus packages, in addition to a multiple-trillion-dollar stimulus package in 2021 from whomever ultimately wins the presidency.

Bottom line, markets are reacting favorably to a balanced government, stimulus and continued Fed liquidity.

One interesting stat…this could be the first time in history that there is a Democratic president, a Democratic House, but a Republican Senate. The primary message from the US electorate: work together.

Market Analysis

Stocks surged today. That may change tomorrow, but the initial reaction to the election was very strong.  The leaders were large caps, technology, biotech and healthcare, and most were up over 4% today.  It is not just stocks that are strong…market strength is widespread across asset classes.  Stocks, bonds and commodities are all higher in response to the election.

Let’s take a quick look at a shorter-term chart of the S&P 500. The first chart below shows stock prices since October 19th.

After a nearly 10% selloff during the second half of October, the S&P has surged almost 8% from recent lows. It is up over 2% today alone.

So much for that contested-election market crash.

Bigger picture, it appears that the market is continuing to consolidate after the massive surge off of the March lows.

The next chart is the daily chart of the S&P 500 this year. Since the September highs, stocks have been moving in a sideways and choppy manner. Today’s action looks like a continuation of that sideways move.

The market is clearly defining what it views as important price levels.

On the upside, if prices can exceed the two blue lines near the top of the chart (roughly 3500 and 3600), then prices could explode to the upside and enter what is called a “melt-up” phase. This could result in dramatically higher prices in a fairly short period of time.

On the downside, stocks have found support in the 3200 area (the blue shaded area in the chart above) multiple times over the past few months. If prices fell below this very important 3200 level, then probabilities rise dramatically that we will see further declines in prices. For now, that probability appears to be the lower likelihood outcome.

Until we see a decisive break out of this range in one direction or another, we should expect markets to be choppy, especially if there are any surprises from the vote counting process.

But the initial strong response by the markets is encouraging. We should expect continued Fed support of the markets, and discussion from the winning side about a multiple trillion dollar stimulus package following inauguration. We should also expect the COVID-related stimulus discussions to restart in Congress now that the election is done.

This is an excellent example of just how little impact these types of events usually have. This is not unusual. The data consistently tells us to pay more attention to what’s really happening under the surface of the market instead of the media-induced frenzy surrounding big events like elections.

Portfolio Positioning

As we have stated before in both this newsletter and during discussions with our clients individually, we do not make allocation and investment decisions based on events. Rather, we simply follow our predetermined process.

What actions have we taken for clients?

  • We have had increased cash exposure for clients since early September.
  • Last week, we had more sell signals get triggered, and entered election day with 25-30% cash, depending on our individual client’s pre-determined risk levels.
  • Today, we had a buy signal in our S&P 500 trend model. This moved 10-15% of portfolios from cash into the S&P 500 Index ETF this afternoon just before the market close.
  • Our signals are showing multiple areas of strength following the recent surge, and anticipate that we will likely get more buy signals in the coming days.

Overall, we have been pleased that our proprietary system has had us with higher than normal cash levels over the past couple of months, and it was reassuring to have extra cash in portfolios going into election day.

For now, our system is telling us that the probabilities favor higher markets over the coming months, but that could change quickly.

During times of volatility, there is the potential for what we call “whipsaws”. This occurs when a buy signal is followed by a sell signal in a fairly quick period of time. In any investment system that analyzes and follows trends, this is a potential risk. We have processes in place to help reduce the negative effects of these whipsaws, but they still happen nonetheless.

We hope this doesn’t happen, but if our signals tell us to be more defensive, we will adjust accordingly.

So expect to have increased activity in your accounts if markets continue to be volatile. The goal is to be positioned correctly for the market we have, not the market we hope to have.

For now, election day is over. The Fed remains supportive. We continue to have a balanced government. These issues are proving to be more important to markets than the actual results of the election or the potential contested nature of it.

All sides of the political spectrum can view yesterday’s results favorably. Democrats appear likely to win the presidency, but Republicans held many seats in the House and will likely have the majority in the Senate.

Maybe this is exactly what we all need. This has been a difficult year for many people, and let’s hope that we can move forward together.

Invest wisely.

Elections and Overconfidence

With less than a month to the election, we look at the dangers of overconfidence, analyze sector performance under tremendously different legislative environments, and discuss whether you should reduce risk prior to November 3rd.

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

-Mark Twain

Overconfidence

Mark Twain’s quote above seems appropriate for the weeks leading up to a Presidential election. It is about overconfidence.

The exact origin of this quote is not completely clear. It is credited to Twain, but many scholars have a hard time tracing it directly to him. Some give credit to one of his contemporaries, Josh Billings, who was a prominent political humorist in the late 1800’s.

Originally, Mr. Billings used it as a jab towards politicians. But over time, it has been used to criticize religion, the military, politics, environmental activists and finance.

This quote was included in the opening scene of an excellent film about investing called “The Big Short”. This movie was based on a book written by Michael Lewis. The main character is a hedge fund manager who bets big against the housing market leading up to the 2008 financial crisis.

The events in the movie are almost entirely true. The main character, who in both real life and the movie is named Michael Burry, was ridiculed for taking a stance that was extremely opposite of the consensus view that housing prices would never fall. By taking this position, he lost clients, lost employees, and almost lost his entire business.

When the financial crisis hit and home values across the country plummeted, he made hundreds of millions of dollars for himself and his clients. (We strongly recommend reading any of Michael Lewis’s books, particularly those about finance. They can be found on Amazon here.)

Both “The Big Short” and Mark Twain’s quote have one major theme…the danger of overconfidence.

An entire generation of financiers were convinced that housing prices would not fall. They were so confident in their belief that the bets they made brought down legendary companies like Bear Stearns and Lehman Brothers. Other companies who made the same bets and should have gone bankrupt are companies like Merrill Lynch, UBS, Wachovia, Countrywide, Fannie Mae, AIG, Washington Mutual, Lloyds and Royal Bank of Scotland. The overconfidence was amazingly broad and well accepted.

Presidential elections represent the apex of overconfidence in modern society.

Each election cycle, we ask presidential candidates to make bold predictions about how they will steer society to a better future. These days, it’s almost a job requirement to have unhealthy amounts of overconfidence. To run for the office, you must either have a massive ego or a very special calling. Usually both.

But presidential elections don’t only bring out overconfidence in the candidates. Investors, and the investment industry as a whole, are just as guilty of this on a very widespread scale.

With less than a month before the election, our inboxes have been bombarded with reports predicting the market outcomes under Trump versus Biden administrations.

All of these reports sound eloquent and well thought out.

But there is one important question…should we listen to any of them?

Previous Legislation by Industry

Nearly every conversation we have with clients and prospects right now includes a discussion about the election. Specifically, people are wondering if they should reduce risk before the election.

When considering an action like this (or any other action for that matter), you must first have a reliable understanding of how effective that implementation may be.

So let’s look at a few examples of major policy initiatives that were both campaigned on, and also legislated into action. And then look at the resulting performance that resulted from that policy action.

Most presidents have domestic policies that are very industry-specific.

President Obama and President Trump are polar opposites in many ways. Perhaps the most contrasting policy initiatives between Obama and Trump were in three main industries: healthcare, financials and energy.

The chart below shows just how different the two men were with regards to legislation that affects these industries.

President Obama passed major legislation that dramatically increased regulations on large financial institutions, energy companies and the entire healthcare industry.

In 2016, candidate Trump ran on an agenda of repealing each of these laws, and to a large extent was successful in removing large portions of them once he became president.

Surely these dramatically different policies would have a noticeable effect on the stock prices of each of these sectors.

Quite the contrary. Under President Obama, here is how these sectors performed annually during his administration:

  • Healthcare: 14.2%
  • Financials: 7.2%
  • Energy: 5.0%

Here are the performance of the same sectors under Trump:

  • Healthcare: 14.1%
  • Financials: 7.1%
  • Energy: -15.8%

Read that again.

Despite the huge differences in policy, the performance of healthcare and financials were practically identical. And energy did much WORSE under Trump than under Obama!

Policy differences sure didn’t lead to stock performance differences in these sectors.

If we look back to 2016, most investment firms were predicting that a Trump presidency would be very supportive for Financials and Energy. They literally couldn’t have been more wrong.

Let’s pick on JPMorgan, one of the more well-respected behemoths of the financial world.

The chart below shows their predictions from 2016 of which sectors would be hurt, and which would benefit under a Clinton versus a Trump presidency.

A green (+) in the column below each candidate represents which sectors they believe would benefit from that candidate becoming president. A red (-) represents which areas they believe that candidate’s policy will have a negative impact on the performance of that sector.

There is quite a bit of data on this chart, but the fine folks at JPMorgan essentially predicted that under a Trump presidency the best performing areas of the market would be Financials, Discretionary and Energy, while the Technology sector (IT in the chart above) would under-perform the broad market.

Just like people are doing in 2020, they laid out a very logical argument on why you should follow their highly intellectual musings and rely on their vast intelligence to guide your investment decisions.

You probably know where this is going.

Despite teams of “experts” in markets, politics, taxes, legislative processes, company fundamentals, and who knows how many other areas of expertise, they were flat out wrong.

Unfortunately, this doesn’t surprise us at all.

Maybe this is just industry-specific. Surely there were meaningful differences in stock performance of various sectors, and possibly the broad market as a whole under such different administrations.

The next chart, courtesy of LPL Financial, shows a more comprehensive sector performance under both Obama and Trump. The Trump data is shown through the end of September. The chart is organized in descending order by sector performance under Obama.

To continue picking on JPMorgan, let’s first look at the column under “Trump”.

Despite massive deregulation for Financial and Energy companies, they were the two worst performing sectors under Trump. Energy stock prices were hit especially hard, down nearly 16% per year. Most large investment firms predicted that energy stocks would be the single biggest beneficiaries of a Trump presidency.

To add insult to injury, Technology, which JPMorgan predicted would be the worst performer sector under Trump, ended up being the best performer BY FAR.

To be fair to JPMorgan, they were not alone in their poor efforts of prediction. Most large firms made very similar predictions, and all were made with a very high degree of confidence. Hopefully these firms didn’t use their overconfidence when implementing client portfolios, because their clients would have suffered dramatically if they followed their own advice. Or maybe they did shift client portfolios, which partially explains why we’re seeing consumer trust in financial institutions near all-time lows.

But if they didn’t shift client portfolios in that direction, why would they go to the effort of making these predictions in the first place???

To finish up with the chart above, it is incredibly interesting to us to see just how similarly the sectors performed under each president. The top two sectors were the same, the bottom two sectors were the same, and the rest were within a few percentage points of each other.

From an overall market standpoint, stock performance is very similar as well. The S&P averaged 12% per year under Obama and 14% per year under Trump.

This is real data.

Despite completely opposite legislation, and despite huge PR campaigns to rally support while the bills were being passed, there was very little difference in performance in nearly every sector.

So what explains the similarity?

It’s the Economy Fed Stupid

One of the more popular phrases during presidential elections was coined by James Carville, one of Bill Clinton’s primary advisors during his 1992 presidential campaign. He said, “It’s the Economy Stupid.”

He meant that how the economy is doing is the single biggest factor in whether an incumbent would win re-election.

Today, the single biggest factor in determining stock prices is simple…it’s the Fed.

We’ve written about this many times this year, and will write about it many times in the future. It continues to be the single most important theme for the markets.

The next chart below shows the Fed balance sheet since 1994. It is amazing just how much money has been printed this year in response to the COVID crisis. The values on the right side of this chart are in thousands. This means that the current Fed balance sheet is $7 million-thousand, or $7 Trillion for everyone on planet earth who is not an economist.

Stock prices have soared on the back of this massive injection of liquidity. Since the Fed started printing in late 2008, markets have relentlessly and consistently moved in tandem with the Fed’s actions.

And there is scheduled to be even more in the coming months, to the tune of nearly $4 Trillion of additional money printed.

This is what makes the market performance so eerily similar between Trump and Obama. The Fed began massive money-printing just before the start of Obama’s presidency. And they have continued until this very day.

Markets are responding to this liquidity by going up, despite what legislation has been passed.

The Fed is making company valuations irrelevant. They are making economic data irrelevant. They are making tax policy irrelevant. They are making geopolitics irrelevant.

And they are most likely making the presidential outcome this year irrelevant as well, at least as it pertains to the stock market.

Someday there will be massive consequences to these actions, but that day is most likely not today.

So What Should We Do?

Will the Fed’s massive support of the stock market help Trump get re-elected?

When the markets are higher in the 3 months leading up to the election, the incumbent president has won EVERY SINGLE TIME.

Will history repeat itself? Who knows. It is 2020 after all.

At this point, it doesn’t seem like that would be a very good bet. Biden has huge, double-digit leads in the polls. But continuing the theme of the danger of overconfidence, we would suggest that based on 2016, the Biden campaign and his supporters shouldn’t get too comfortable.

The final chart below shows the probability that Donald Trump will win during the days leading up to the election in both 2016 and 2020. This chart was derived from the betting odds via RealClearPolitics, and shows the likelihood of him winning versus the number of days left until the election.

At this same point in the election cycle, Trump had a 20% LOWER probability that he would win the election in 2016 than there is now. And the pattern is eerily similar.

So anyone confident that they know who will win the election is simply guessing, or more likely just trying to sway public opinion.

Should You Reduce Risk before the Election?

Let’s get back to the original question we keep receiving from clients, which we haven’t answered yet…”Should we reduce risk before the election?”

Bottom line, no. At least not as of the time of this newsletter.

And the other primary question…”Should we listen to the pre-election predictions?”

Once again, no. Don’t listen to the ivory tower academics at the large investment firms. They are most likely going to be wrong, despite spending lots of resources on trying to sound smart. And just like everyone else, if they were right, it’s as attributable to luck as anything else.

Our investment process raised cash for clients in early September, not because we were predicting volatility around the election, but simply because the market became volatile and we followed our predetermined process. As a result, most of our client accounts moved to roughly 25-30% cash.

The S&P 500 proceeded to declined 10% in September. Frankly, we thought that our system would likely keep us with increased cash exposure into or past the election. However, last week we had multiple buy signals. And despite the election drawing closer, our system had us increase stock exposure across the board, not decrease.

Now, the market is back to flirting with all-time highs. Despite the pending election, stocks are moving higher.

One thing is for certain…STAY NIMBLE.

Just because we invested in stocks last week doesn’t mean we will stay at our current investment exposures from now to beyond the election. A lot can happen, especially in this crazy year. We have our exits already mapped out in case volatility does return, so if our system tells us to move funds back to the sidelines, we will do it.

And if we do raise additional cash before the election, it does not mean that it will stay in cash long. We have predetermined buy signals to get our clients back in.

The anticipation of market volatility around the election is normal. It will happen this election, and will likely happen in every election for the rest of our lives.

The Lesson?

The main lesson is that you should create a process that is agnostic to anticipated risk.

The expectation of risk is greatly different than the realization of risk.

Adapting your portfolio when risk happens is key. When markets actually start to realize risk is when you should adapt, not when you think risk should happen.

Way too many investment managers fall victim to the same overconfidence that politicians and financiers make, and use their “experience” and “intuition” to make adjustments based on what is nothing more than guesses.

Don’t let it happen to you.

Most of our clients have heard us say this before. We don’t know what the market will do in the future. No one does.

And that’s okay.

Don’t try to guess when volatility will happen. Chances are that you will be wrong. And if your investment advisor is trying to guess when volatility will happen, they should stop also because chances are they will be wrong too.

By following a predetermined process, we don’t have to worry about the possible effects of the election on our clients’ portfolios. Our system will adapt to whatever the future may bring.

The best part of this process is that it allows us to have comfort in the fact that we don’t have all the answers right now. We don’t have to worry about whether we should worry about the election.

The most important thing to the market right now is not the president, but the Federal Reserve chairman. If that were to change, markets could undergo dramatic increases in volatility. But that appears to be very unlikely under either Biden or Trump.

Bottom line, the trend in the market is higher, and has been since the March lows. Valuations are stretched in many areas, but it simply doesn’t matter at this point. Don’t miss out because you think that the market should be volatile around the election. A pre-set plan will help greatly reduce the worry you may experience around big events like the election.

Then you can worry about more important things…like how a country of 330 million people can produce these candidates as our two primary options.

Invest wisely!

Our clients have unique and meaningful goals.

We help clients achieve those goals through forward-thinking portfolios, principled advice, a deep understanding of financial markets, and an innovative fee structure.

Contact us for a Consultation.

Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.  Disclaimer This presentation is for informational purposes only. All opinions and estimates constitute our judgment as of the date of this communication and are subject to change without notice. > Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.

Does GDP Matter to Stocks?

Sometimes what should make sense simply doesn’t. This is especially true this year. We just witnessed the worst quarterly economic data in history, yet markets have now officially made up all of their losses from the COVID crash. This begs the question…does GDP matter to stocks?

“A man should look for what is, and not for what he thinks it should be.”

-Albert Einstein

Well, that didn’t take long.

Despite staggeringly high unemployment, the worst economic data in a century, a pending presidential election, social unrest and over 800,000 deaths worldwide from COVID, the S&P 500 index has officially made back all of its losses from earlier this year.

After making an all-time-high on February 19th, the S&P 500 then went on to set some pretty unfortunate records. The resulting 37% decline was:

  • The fastest 10% decline from all-time-highs in history.
  • The fastest 20% decline from all-time-highs in history.
  • The fastest 30% decline from all-time-highs in history.

In addition to these records, the Dow Jones had 12 separate days where it fell over 1,000 points during the course of a day. That only happened once in history before this year.

As unprecedented as the decline was, we have now experienced an equally unprecedented recovery. On Monday, the S&P 500 fully recovered the entire decline, surprising many people in the process.

The size of this decline and recovery is not unusual. It is the speed at which it occurred that is so amazing.

There have been 15 bear markets since 1956, as shown in the first graph below. This is courtesy of Ryan Detrick of LPL Research, who is becoming one of our favorite analysts to follow.

This graph shows the length of the bear market, the percent decline during that period, how long it took the market to recover, and whether or not there was an official recession.

Let’s focus on the last three rows that summarize the data.

It is interesting to note that not every bear market led to a recession. Of the 15 bear market environments, only 8 were accompanied by a recession. (This is where the popular saying “the stock market has predicted 10 of the past 5 recessions” comes from.)

The average decline of these 15 bears was 30% and occurred over a 12 month period. And, on average, it took 20 months for the market to fully recover those losses.

There is no doubt that we are currently in a recession. If we only focused on the environments that had both a bear market AND a recession, then the average decline increases to 37% over 18 months, with an average recovery time of 30 months.

The fall in stock prices we saw in March is right in line with the average bear market. However, instead of taking 18 months, it took just over ONE MONTH for the decline to occur. This recovery only took 5 months, instead of the average 30 months for prices to recover.

Wow.

(NOTE: This particular chart was published last week before the market officially made new highs. It also shows a 34% decline for the S&P 500, which was the decline on a closing basis, or only based on prices at the end of each trading day. The intra-day decline was over 37%.)

The speed of the decline and recovery speaks to just how unique this environment has been. This is the first government imposed recession outside of a global war, at least in the US. It did not start within the economy itself. There was no excess supply of goods, or an organic decline in demand. It was the result of governmental policies aimed at slowing the transmission of an extremely contagious and uncertain virus.

For many people, this dramatic rebound doesn’t make sense when combined with so many uncertainties. In many ways, we agree. Despite this strong run, there are plenty of reasons to be skeptical about the stock market.

But should we be skeptical?

GDP and Stock Prices

There are dozens of ways we could analyze the current environment. But let’s focus on the big daddy…GDP.

Of the many data economic data points from this year, perhaps GDP is the most profound. (GDP is Gross Domestic Product, or the total economic output of a region.)

In the second quarter, US GDP fell a whopping 32.9%, as shown in the next graph from an article by NPR.

This recession is far deeper than any previous one. The decline in the second quarter was greater than any previous quarterly decline, even including the Great Depression (which is not shown in this graph).

It seems logical that the stock market should be tied to economic output. A rising economy should result in rising stock prices, and vice-versa. It would also seem logical to expect to see a rise (or decline) in stocks that is proportional to the rise (or decline) in the economy. In other words, an economy shrinking faster should result in a proportionally weaker stock market.

The market fell 56% during the 2008 financial crisis. GDP fell much further this year, yet stocks “only” fell 37%. The market should be about to start a decline that is proportionate to the decline in the economy, right?

While that may happen, we should not expect it to happen. Why not?

The answer may surprise you.  tock prices are simply not that correlated to GDP.  At least not in real time, and at least not when looking at GDP alone.

We know there are some of you that are surprised, even shocked, to hear us suggest something like this, but stay with us, it won’t be as shocking when we’re done.

Before we dig into the data, let’s first have a quick statistics tutorial.

One way to look at correlation is with a scatter plot chart. Scatter plots show one data set on the y-axis (up and down), and another data set on the x-axis (left-to-right).

When two data sets are plotted on the same chart, we can then easily see what type of correlation there may be between the two data sets.

There are essentially three types of correlation:

  • Positive
  • Negative
  • No Correlation

Visually, it looks like this.

Positive correlation is what we should expect out of a relationship between GDP and stock prices. Higher GDP should, in theory, correlate with higher stock prices. The line should be going up and to the right.

There are varying degrees of correlation as well. Not everything is perfectly correlated, and we shouldn’t expect that out of stocks. But we should expect to see a relationship between the two.

So let’s look at the data.

The first scatter plot below shows the Wilshire 5000 Index versus GDP, from 1970 through 2019. The Wilshire 5000 is the most comprehensive of all stock indexes, and most closely resembles the US economy. (Ironically, it currently represents only 3500 companies, but was composed of 5000 companies when it was introduced in 1974.)

Each dot represents one year, and shows the performance of the Wilshire and GDP growth for that particular year.

What do we notice? For starters, it sure does look like the “No Correlation” example above.

Again, if stocks were correlated to GDP, the dots should be in a pattern that generally went from the bottom left to the upper right. A rising GDP would be associated with a rising stock market. So the strongest GDP years would have the strongest stock market performance.

But that simply is not the case. If we look at just about any of the GDP numbers, stock performance is all over the place.

A year with 4% GDP has had market performance anywhere from up over 30% to down more than 20%. Even the strongest economic years had both positive and negative performance.

Despite seeing this data, it doesn’t make sense that they would not correlate at all. Surely there is a way to see a connection between economic activity and stock prices.

Stocks vs the Following Year’s GDP

Markets are discounting mechanisms. This means that they are not looking at what is happening right now. They are looking into the future and trying to anticipate future conditions. They are forward-looking.

Maybe the current year’s stock price is more reflective of next year’s GDP.

This would make sense as well. By the time GDP falls, the market has already fallen. The same holds true when markets and the economy rebounds.

Let’s look at the same data, only with GDP shifted forward one year. The next chart below shows this. Instead of showing both stock returns and GDP for 1990, it shows stock returns for 1990 and GDP for 1991 for example.  We shouldn’t expect the correlation to be perfect, but it seems like it should show somewhat better correlation, right?

This is still a random collection of dots with no correlating pattern.

Obviously, calendar-based analysis has its own flaws, as bear markets and recessions don’t start and stop at year-end. But that isn’t enough of a reason to show no correlation at all.

We have mentioned in previous newsletters and in nearly every client conversation that the primary reason stocks are higher is actually quite simple…it’s the Fed.

Stocks vs M2/GDP

The Fed has been massively increasing the money supply, which made its way into stocks, resulting in higher prices. One of the primary measures of the amount of money available to go into various assets is known as M2.

M2 is a measure of the money supply that includes cash, checking deposits, and funds that are easily converted to cash, such as money market funds and savings accounts (source: Investopedia). M2 is also a target of central bank monetary policy.

If we incorporate the money supply into the equation, we now start to see some very strong correlations.

Let’s look at some analysis from another one of our favorite research analysts, Tom McClellan.

The next chart incorporates M2, GDP and stock prices, shifted forward one-year. The black line is the S&P 500, and the red line is M2 divided by GDP.

When the red line is rising, that means that the money supply is growing faster than GDP. This can happen when the Fed prints money (the numerator rises), or when GDP is falling (the denominator is falling).

As noted on the chart, when there are large surges of the M2/GDP ratio, the markets tends to have big surges as well. The correlation is very easy to see, even if it is not on a scatter plot.

There is a massive surge in this ratio right now. This chart was published before the Q2 GDP announcement came out, and assumed a 4% drop in GDP for the second quarter. The big spike on the right is literally off the charts now that the actual GDP number is a negative 33%.

Not surprisingly, the market is seeing a big surge higher in prices as well, despite all of the economic damage.

This chart confirms what we have been saying for some time now. The Fed is what matters, not the underlying economic data.

In fact, this type of correlation shows just the opposite of what we were looking for initially. Stocks aren’t LEADING the data, they are FOLLOWING the increases in overall liquidity.

It speaks to just how much the Fed has skewed markets in the modern era. The fact that we can analyze data showing very little connection between economic performance and market performance is truly stunning. And the gap seems to be increasing dramatically this year.

The primary question then becomes, “How long with this last?”

Unfortunately, we have no idea.

Maybe the economy catches up to the market. Maybe the market catches down to the economy. Maybe they continue live in alternate universes.

But with the M2/GDP ratio surging, with the Fed continuing to pump trillions of dollars into the financial markets, and with stocks breaking to new all-time highs, it is only logical to assume that rising stock prices should continue for some time. And it will likely be measured in years, not in months.

Since April, our signals have consistently been telling us that this is a risk-on environment, at least in the near-term.

Longer-term becomes more tricky. We will write more about this in the future, but our view is that we are in the late stages of a long-term debt cycle that began in the early 1980’s. There have been many debt cycles in history, and unfortunately every one of them have ended poorly.

Our best guess is that the next major down cycle will begin when markets lose confidence in the Fed.  But that may be many years into the future.

For now, we are in a period where you can take advantage of rising prices. Nothing goes straight up, and there will be bumps along the way. You must have a predetermined risk management process that can reduce risk when the music eventually stops.

But as of now, the trend is favorable, and the environment is a positive one for risk assets. And we should operate under that perspective until prices tell us it is time to change.

Invest wisely!

Our clients have unique and meaningful goals.

We help clients achieve those goals through forward-thinking portfolios, principled advice, a deep understanding of financial markets, and an innovative fee structure.

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Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.  Disclaimer This presentation is for informational purposes only. All opinions and estimates constitute our judgment as of the date of this communication and are subject to change without notice. > Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.