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inflation

5 Themes for 2022 and Why We Hate Year-End Predictions

Fortune teller reading future with crystal ball. Seance concept.

We hate year-end predictions.

Maybe “hate” is the wrong word…it is far to kind.

We absolutely despise the cringeworthy year-end predictions that accompany this time of year. (Feel free to imagine other colorful adjectives we may use to describe them.)

Why?

  1. Because they are worthless.
  2. There is no accountability whatsoever for those who make them.
  3. There is no way to accurately predict such a complex system as the global financial markets with any consistency, other than using the most commonly occurring outcome of an historical return bell-curve.
  4. Did we mention they were worthless?

Case in point…the six largest investment firms in the world missed last year’s performance by nearly 20 percentage points on the S&P 500. Oof.

Our apologies in advance if you’re looking for our wild-ass guess expertly modeled estimate of what the S&P 500 will be on December 31, 2022.

As our clients hopefully know, we don’t try to predict what will happen. Instead, we try to listen intently to the markets and let our rules drive the investment decisions.

So instead of sharing our predictions, let’s instead share the five themes we’re tracking for the upcoming year.

Theme 1: The Fed

For those who regularly read our reports, there’s no surprise here that the Fed holds the top spot in themes we’re watching this year.

The Fed is the Alabama Crimson Tide of the financial world. They are always among the top few drivers of what will happen during the season. And unless you’re on the team or an alumni, most people are pretty tired of you by now.

More accurately, the Fed IS the driver of the market. It has been since 2009. So we MUST pay attention to what they are doing.

Right now, despite the talk from Chairman Powell about tightening and raising rates, they are still expanding their balance sheet.

Federal Reserve Balance Sheet has been increasing despite Powell saying they are tapering.

The increase in the Fed’s balance sheet is the single biggest contributor to both the increase in the stock market, as well as the re-emergence of inflation across the globe.

It is also a reason why we’ve only seen minor pullbacks since COVID began.

The eventual reduction by the Fed is very likely to lead to a much choppier environment for stocks, and at some point an outright bear market.

Whether that happens in 2022 or not is anyone’s guess.

But as of right now they are scheduled to begin reducing their balance sheet this year, not just slowing down the increase of it.

Paying attention to global markets when the Fed ACTS, instead of when they SPEAK, will be key for risk assets this year.

Theme 2: Inflation

The second theme to watch this year, and the natural follow up to the Fed, is inflation.

We’ve all seen it recently. From cars to steaks to milk to $10 packets of bacon. Everything costs more.

In fact, inflation just recorded the largest year-over-year increase in 40 years. It rose 7% in the past 12 months, as shown in the chart below.

On the surface, this looks ominous. We haven’t seen an inflationary environment since the 1970’s, and that decade was not a good time to passively invest in stocks.

However, our belief is that inflation will not increase and stay at elevated levels.

Instead, we think it will occur in waves.

We wrote about inflation numerous times last year (click to read):

Lumber is a good example of our inflation-wave thesis.

After skyrocketing the first part of 2021, lumber prices subsequently collapsed. Now, they are skyrocketing again.

Take a look at the extreme moves in lumber recently.

This chart is pretty amazing. We’re talking about the price of LUMBER. Not some phantom crypto-coin being schlepped by a Kardashian.

Lumber is an excellent case study for this environment. There are demand influences, supply chain issues and quality differences in various types of lumber that contribute to this massive volatility. And for the most part, it does not have governmental influences on it like the cost of healthcare does.

Inflation has far-reaching ramifications. Not only for asset prices and the economy, but for society as a whole.

Higher prices hurt consumers. They hurt businesses without pricing power. They cause massive price adjustments in all sorts of areas. Inflation also has massive political implications as a disgruntled populace focuses its frustrations on political leaders.

This quote by John Maynard Keynes is fairly long, but worth the read:

By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers,’ who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

– John Maynar Keynes

Sounds pretty applicable to today. It was written in 1920.

We don’t expect inflation to cause massive societal disruptions this year, but we sure can see the foundation being laid for that to happen.

Inflation needs to be near the top of things to watch this year. And the coming decade for that matter.

Theme 3: Interest Rates

The third major driver of markets and the economy is the prevailing interest rate environment.

The COVID Crash in March 2020 pushed yields to their lowest levels in history. Not just recent history. All-time history. In the entire history of recorded financial records, dating back to ancient Egypt 4000 years before Christ, interest rates were never lower than they were two years ago.

Since then, they have marched higher. And they are currently trying to move beyond their highest levels since COVID began, as shown in the next chart.

Higher interest rates affect many areas. Real estate, fixed income markets and global currencies all have some sort of tie to interest rates. Not to mention more complicated instruments like derivatives and futures contracts.

Stocks are a bit different.

Higher interest rates aren’t necessarily bad for stocks all the time.

In fact, stocks tend to do just fine when rates rise.

The next chart, courtesy of LPL Financial’s Ryan Detrick, shows the performance of the S&P 500 each time the 10-year yield has risen by more than 1.00% (or 100 basis points).

Since 1962, there have been 14 times when the 10-year Treasury yields has risen by more than 100 basis points. Stocks were higher 11 of those times by an average of 17.3%.

Granted, most of these periods occurred during the massive bull market we’ve had over the past 40 years, but this is still an impressive statistic nonetheless.

While parts of the market are likely to suffer as interest rates rise, we shouldn’t assume that higher interest rates will automatically make stocks go down.

We are likely to find out if this holds true again this year.

Theme 4: Risk Makes a Comeback

The S&P 500 had an excellent year in 2021. CNBC and most financial news outlets primarily focus on the performance of this behemoth index.

But last year did have its share of risk if you looked outside of the large cap growth stocks.

The chart below shows the performance of various assets since last February.

The S&P is the leader by far. It was up almost 22% before the turn of the new year, since last February alone.

However, other assets didn’t perform so well during that same time:

  • International stocks were barely higher (Up 3%)
  • Small Caps lost value (Down 7%)
  • Emerging Markets down big (Down 13%)
  • China was substantially lower (Down almost 30%)
  • Even the high-flying ARKK investment ETF, run by Cathie Wood and epitomizing the speculative edges of the markets, fell by nearly 50% since last February.
  • Bitcoin is down nearly 40% in the past two months (not shown on the chart above). Not what we consider to be an effective a store of value, especially with inflation at 7%.

Why did the S&P returns exceed other areas of the market so much?

Simple…nearly 30% of the index is in the top 5 stocks. And those stocks did amazingly well last year.

The rest of the financial world experienced weakness or outright bear markets already.

The main question for this year is whether the rest of the world can do well if the top stocks in the S&P 500 do poorly.

If they can, which is an excellent possibility, then there will be more opportunity in owning things outside of the big tech companies. In our view, this is the likely path forward.

But if they can’t, and the rest of the world remains weak while the heavy lifters in the S&P 500 deteriorate, then it could be a difficult year across the board.

There are mixed messages here, and the answers are not clear. So you must adapt as the things develop, whether they become bullish or bearish.

Theme 5: Another Damn Election

It’s a mid-term year, and the fully saturated political environment is going to soak us once again.

In an ideal world, politics shouldn’t influence asset prices. But in our world they do.

Remember the performance of Chinese stocks from the chart above? A number of Chinese companies have excellent business models, fantastic customer bases and thriving businesses, but political influences caused massive declines in the performance of their stock last year, and it brought down the entire stock index in that country.

With this being an election year, there are some key areas of the market that could be made into whipping boys this year.

The two most likely targets? Big Tech and Big Oil.

We’re starting to hear rumblings from Washington about their intentions.

The big social media companies are scheduled to testify to Congress soon. And our beloved politicians won’t miss the opportunity to send an outlandish quote hurling through the echo chamber to get on the front page nationwide.

Same with big oil. We’re already hearing from President Biden that oil companies are gouging the American people. Maybe he’s right, maybe not. But we should expect them to be a target this year as well.

Despite of whether there is political influence or not, midterm election years tend to have increased volatility on average.

The next chart, again courtesy of LPL Financial, shows This chart shows the average return of each year of the 4-year Presidential Cycle since 1950.

Specifically, it shows that Midterm years have an average drawdown of 17% during the course of the year.

It also shows that on average, stocks are higher by 32% a year after the lows.

While each year has its own specific characteristics and abnormalities, the Presidential Cycle data suggests we should see some volatility this year, but should expect a nice recovery.

Bottom Line

Bottom line, the market is finishing up a strange year in 2021. The S&P 500 did great, but other areas didn’t do as well.

And markets are off to a fairly rocky start to the year so far. But the overall trend still remains higher, at least for now.

Where the market ends up at the end of the year is anyone’s guess. But we’ll keep adjusting portfolios as the data warrants, and will work hard to both protect and grow your hard-earned wealth.

Invest wisely!

The Wolf and the Crane

Aesop was a Greek storyteller who lived from 620-564 BCE. His stories were verbally passed down through time, and often included tales of animals and inanimate objects that could speak and solve problems.

Many of Aesop’s Fables are commonplace even to this day. We are all familiar with the story of the tortoise and the hare.

But a lesser known fable is that of the Wolf and the Crane.

In the fable, the Wolf gets a bone stuck crosswise deep in his throat. He asks the Crane, with her long neck and lengthy bill, to reach in and pull the bone out. If she successfully removes the bone, he promises to reward her very handsomely in return.

So the Crane uneasily put her head into the Wolf’s throat, and removes the bone.

But when the Wolf felt that the bone was gone, he started to walk away.

The Crane anxiously asked, “But where is my reward?“

The Wolf whipped his head around and snarled, “Haven’t you already got your reward? Isn’t it enough that I let you take your head out of my mouth without snapping it off?”

The moral of this story is that you shouldn’t expect a reward when you are serving the wicked. (FYI, the full text of the fable is at the bottom of this page.)

This may seem harsh, but it is appearing more and more that the Fed is the Wolf.

And we are the Cranes.

We have benefitted from 12 years of strong markets on the back of the Fed printing press. The excesses of the banking and housing expansion before 2009 were never truly worked off. Only covered by a tsunami of digital dollars.

The Wolf, aka the Fed (and more broadly the largest U.S. banks), asked us to do something for them: increase consumption by using low-interest debt. Oh, and to buy stocks.

And we consumers obliged.

Total consumer debt has consistently risen over the past 30 years, as shown in the chart below.

Total consumer credit since 1990

Consumers benefitted in the form of easier access to credit and interest rates that are literally the lowest in recorded human history.

Investors benefitted as well.

The next chart, courtesy of our friend Lance Roberts with Real Investment Advice, shows the Federal Reserve balance sheet versus the S&P 500 Index. We discussed this chart in our Strategic Growth video series HERE.

Each time the Fed turned on the printing press since 2008, stocks went up. After all, this was the goal of their policy. They wanted stocks to go up in order to create confidence in the real economy.

Flooding the financial system with liquidity worked, and it continues to work to this day. If we look at all the problems in the world right now, it is easy to see that U.S. stocks simply don’t care about any of them.

GDP cratered over 30% in the second quarter of 2020. We’re in a global pandemic that is nearly two years old. There is massive unemployment, huge inflationary pressures, supply chain disruptions, major tax legislation, self-induced geopolitical messes, natural disasters, generational social discord, increasing wealth disparity…the list goes on.

Despite all of this uncertainty, we haven’t had a 5% pullback in almost a year.

As Jay-Z might say, “I got 99 problems but the market ain’t one”.

At least not yet.

This summer we wrote The Fed is Stuck. In it, we discussed the mechanisms that allowed the Fed to have a direct impact on financial markets.

Now, there is discussion that the Fed will start to reverse course.

Over the next few months, you’re going to hear a LOT of the word “taper” from the financial media. And rightfully so.

The Fed has created an economy and financial system completely dependent on its easy money policies.

If we can agree that the massive liquidity injections had a positive effect on the markets, one would also assume the opposite to be true.

So it is logical to begin to discuss the potential consequences as the Fed begins to reduce its support of the financial markets.

What Happens when the Fed Tapers?

Merriam-Webster defines “taper” as a verb that means “to diminish gradually”.

When the Fed “tapers” its asset purchases, it simply means they will slowly reduce the amount of money they are force-feeding into the financial system.

This HAS to happen at some point.

There is no way to continually print trillions of dollars and expect to not have any consequences.

So far, the only “consequences” have been mostly positive.

Inflation has been a consequence, but up to this point it has only been in the form of asset price inflation. Stocks have risen, bonds have risen, and real estate of all kinds have risen.

Federal Reserve Chair, Jerome Powell

What we haven’t seen is the negative inflation that will inevitably stall the economy. But it is starting to appear. In Austin, multiple restaurants have started to raise prices. Your grocery bill is likely a bit higher this fall than it was a year ago. Let’s not even talk about housing affordability.

At first, we the consumer will absorb the real economic inflation. But as these inflationary pressures build, the Fed simply can’t continue on its current path. We are nearing a point where the Fed must stop doing what it is doing.

So what is the Fed actually doing?

It is doing two things: shoveling $120 billion per month into the financial system and keeping interest rates artificially low.

So there are technically two things the Fed could start doing: reduce the $120 billion number, or increase rates.

Taper or Raise Rates?

At their meeting next week (September 21-22), it is widely expected that Jerome Powell will announce a tapering program.

This means that they are likely to reduce the $120 billion number. That leaves two very simple questions: By how much will they reduce it, and over what timeframe?

While most people are predicting the Fed to taper, it actually might make more sense for them to raise rates first.

The financial markets have been focused on the flow of assets into the system. The $120 billion per month results in a net increase in demand. When demand outpaces supply, prices go up. A reduction of the $120 billion would then logically either slow the rate of increase in the market, or at some point lead to an actual price decline.

But an increase in the interest rate environment would have a more subtle effect.

Adjustable rate debt would go up. The interest rates on new loans would likely go up. And what would essentially happen is the cost of funds would get slightly more expensive to slow down major purchases and leverage.

This would be a good thing in the early stages of an inflationary environment.

It also would result in a positive surprise to the financial markets.

That said, it’s very difficult to predict what the Fed will do. And even more difficult to predict how the market will react to it. We’ve yet to read much about the potential for the Fed to raise rates before slowing down their asset purchases.

Either way, it would be more of a surprise if they did NOT act next week.

So we should expect a clearer path forward from Mr. Powell next week, and a path that includes a slow down of Fed activity.

The Wolves Inside the Fed

One other reason to expect a tapering announcement next week is less grounded in economic reality, and has more to do with political grift.

Members of the Federal Reserve do not have major restrictions when it comes to their own personal investments. Or at least they didn’t until last week.

As former employees of large investment firms, we have dealt with trading restrictions for many years. Heck, even a small, independent firm like IronBridge has trading restrictions and requires disclosure of investment holdings. These are important so that we aren’t abusing our knowledge of future trades that we may do for all of our clients, and “front-run” the trade hoping our investment actions will boost the price of that stock.

However, the Federal friggin’ Reserve bank, the most powerful financial institution on the planet, does not have restrictions on what their active, policy-creating members can and can’t do.

Case in point…last week it was revealed that the Federal Reserve Bank of Dallas President Robert Kaplan (pictured below) owned nearly 30 positions in individual stocks valued at over $1MM per stock. He had 22 stock purchases last year of over $1MM per trade.

Dallas Federal Reserve President Robert Kaplan, aka a Wolf

Mr. Kaplan actively sets monetary policy. And that policy is designed to literally make stocks go up.

Conveniently, as the Fed is about to change course and start to taper, he announced that he magically found his ethics and will sell all of his individual stock holdings.

Funny how that works.

Mr. Kaplan isn’t the only one either.

Boston Fed President Eric Rosengren conveniently found ethics as well. He announced he would be selling all of his individual stock holdings by September 30th.

There are only 12 people who officially vote on Fed policy. And two of them (that we know of) are going to liquidate their holdings at the same exact time the Fed is changing their easy money policy.

This is a different kind of wolf, but a wolf nonetheless.

Maybe it is coincidence. Maybe these gentlemen are noble, ethical people. Maybe the Fed won’t reverse course and will keep pumping. Maybe stopping the massive amounts of liquidity going into the system isn’t going to slow this market down.

Or maybe they know exactly what they are doing.

And maybe like the Wolf, they won’t care what happens to the market and economy when they stop.

After all, we Cranes escaped the financial crisis and COVID crash with stock prices and home prices higher than when it all started.

Cognitive Dissonance

The other thing to watch in next week’s meeting is that the Fed will likely blame everything but themselves for the inflationary pressures building in the real economy.

This cognitive dissonance is important because it allows them to change policy without worrying about the negative consequences of what their change in policy might do to asset prices and the real economy.

This allows them to sleep at night believing that what they did was noble.

And maybe it was noble.

But if there begins to be negative fallout from the Fed stopping the printing presses, we should not expect the Fed to reverse course this time. In fact, we should expect the opposite going forward.

The Fed believes we have already received our rewards. We were “saved” from the jaws of the financial crisis and COVID crash.

The Fed didn’t chew the heads off of us Cranes. They “let” us escape unharmed.

And for the first time in many, many years, it appears that they are truly about to change from an easy monetary environment to a less accommodative one.

Therefore, now is not a time for complacency.

The markets are getting closer to a major top. We may not be there just yet, but we are definitely getting closer.

We don’t know if it will be three months, six months or five years before things change, but we are closer today than we were yesterday.

So stick to the basics:

  • Stay disciplined. Don’t let a small loss turn into a big loss.
  • Do not let your emotions get the best of you. Don’t become overly bullish or overly bearish…anything can happen.
  • It’s okay to be wrong. We can’t pick the top. And we won’t try. But if things are not working you need to change course. What’s not okay is to stay wrong and try to fight the market.
  • Use data to make decisions, not narratives. Always remember that the media exists to sell commercials, not give you objective investment advice.

So let’s watch what the Wolves will do next week with great interest. Whatever the Fed may do, we will be prepared.

Invest wisely!

The Wolf and the Crane

“A Wolf had been feasting too greedily, and a bone had stuck crosswise in his throat. He could get it neither up nor down, and of course he could not eat a thing. Naturally that was an awful state of affairs for a greedy Wolf.

So away he hurried to the Crane. He was sure that she, with her long neck and bill, would easily be able to reach the bone and pull it out.

“I will reward you very handsomely,” said the Wolf, “if you pull that bone out for me.”

The Crane, as you can imagine, was very uneasy about putting her head in a Wolf’s throat. But she was grasping in nature, so she did what the Wolf asked her to do.

When the Wolf felt that the bone was gone, he started to walk away.

“But what about my reward!” called the Crane anxiously.

“What!” snarled the Wolf, whirling around. “Haven’t you got it? Isn’t it enough that I let you take your head out of my mouth without snapping it off?”

The Fed is Stuck

Despite economic data showing massive improvement from the COVID recession and inflation running hot across all parts of the economy, the Fed continues to pump trillions of dollars into the financial system. Why? They know that if they stop, things will come crashing down.

It is well that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

Henry Ford

The Federal Reserve board met earlier this month to discuss their interest rate and bond purchase strategy.

Following the meeting, markets fell nearly 2% on terrible news that surely signaled the Fed was going to finally pop the massive bubbles across the markets and economy.

What news was that?

Instead of raising interest rates in 2024, they were considering doing it in 2023 instead.

WHAT???

You can’t make this stuff up. Markets sold off hard because the FIRST interest rate hike might occur 2 years from now instead of 3.

Granted, markets (as they often do), reassessed the situation and realized that the Fed just brought a huge case of booze to spike the punch bowl even more, despite the party-goers being ragingly inebriated and in no shape to consume more. Markets promptly recovered those big losses.

But inflation is obviously running hot. The economy is obviously improving. There are millions of job openings. Employment data would be incredibly strong if government stimulus had not made it more profitable for people to not work than getting many lower waged jobs.

Despite things being in much better shape than it was a year ago when the Fed flooded the market with liquidity, they continue to add $80 Billion each WEEK into the financial system.

Why?

The answer is pretty simple…they are stuck.

They will tell you the reason is that inflation is “transitory”. (This is a word you are likely to hear way too much of in the coming months.)

In some ways, inflation is transitory. We recently shared a brief blog post “The First Wave of Inflation is Receding“, where we showed that lumber prices fell over 50% from recent highs.

Let’s share the chart of lumber in case you missed that report. (We published it on social media, so be sure to follow us for the latest reports.)

Lumber prices skyrocketed but have fallen over 50% since earlier this year.

In just over one year, lumber prices went from under $300 per unit to over $1700.

These are crazy price movements.

As soon as everyone was predicting that inflation was here to stay, lumber prices fell 52% in a matter of weeks.

Human Behavior and History

The price of lumber is exactly what we are talking about when we discuss inflation waves. Our thesis is that inflation will not just immediately come upon us and stay. Instead, it will ebb and flow into the economy in gradually increasing levels.

This thesis is based on both human behavior and history.

The impact from human behavior is pretty easy to think about. Let’s look at the recent increase in home values and lumber as our primary example:

  • The pandemic locked people in their homes.
  • People became tired of their homes. They wanted a bigger/nicer/different place from which to live and work.
  • Demand for homes started to increase.
  • Increased demand for homes caused increasing demand for lumber.
  • Homebuilders and other opportunists saw the price of lumber increasing and started to purchase lumber for future projects. Aka, “hoarding”.

This is how inflation works. Prices begin to rise, and it makes more sense to buy something now, because it will most likely become more expensive in the future.

Inflation can, in fact, be self-fulfilling. High prices tend to lead to even higher prices. It’s FOMO, the “fear of missing out”.

While at first inflation supports even more inflation, there comes a point where it is also self-correcting.

Prices reach a level where it simply doesn’t make any sense to buy it. Whatever “it” is.

This is what happened with lumber. Prices simply became too expensive and people stopped buying it.

We’re not winning any Nobel prizes in economics for this one.

The pace of home building slowed down, and people stopped hoarding lumber. Things just got too expensive. When demand slows, prices tend to fall. Voila. Lower prices.

This is what the Fed is banking on. They believe that inflation is “transitory” because they believe in the self-correcting mechanism of inflation itself. They believe that human behavior will naturally keep a lid on the inflation rate.

Janet Yellen, the US Treasury Secretary and former Fed Chair, said last week that she expects to see 5% inflation this year, but that it will drop to 2% by sometime later this year or in 2022.

Current Fed Chair Jerome Powell blamed inflation on supply bottlenecks in various ports across the globe. He suggests that once this bottleneck gets resolved, inflation will decrease as a result.

Here’s a great article from Reuters about it:

https://www.reuters.com/article/us-usa-debt-yellen-inflation/yellen-says-inflation-should-be-lower-than-current-levels-by-year-end

In the short-term, they are probably right…inflation does tend to self correct.

But higher prices also can be sticky.

Why? The expectations of sellers increase.

Let’s say you are going to sell your home. Over the past few years, homes have sold for $800k-900k pretty regularly in your neighborhood. So you list your home for $900k.

But you just saw ten of your neighbors’ homes sell for $1.2MM. Two even sold for over $1.4MM, but maybe they had done some upgrades. What would you do? Probably increase your sales price (either officially or just mentally) to $1.2MM. That is the new floor.

Homes didn’t stay at the peak sales price. But they stuck at a level higher than the previous prices. Not quite as high as the highest price point, but significantly higher nonetheless.

Outside of a crisis, either personally or economically, you’re probably not going to ask for less than what the average or most common sales price has been. Your expectations have caused a stair-step higher in price. Two steps forward, one-step back.

Thus, we have our first inflation wave.

Simply from human behavior.

These inflation waves happened before. We are no different than previous generations, other than the fact that our access to information is much more easily and quickly accessible than in the past.

We discussed the historical reasons for this theory in “The Coming Inflation Waves“, so we won’t go back over the details. We’ll only say that every inflationary cycle over the past 300 years has started in this way, so it’s a pretty easy bet that it will happen the same way again this time. Humans are, after all, still human.

That does not mean the coming inflation cycle will be easy to predict with regards to timing and magnitude.

The price of lumber should not have risen by THAT much over the past year. But it did. And we have one group to thank…the Fed.

The Fed’s easy money policy for over a decade has put massive amounts of liquidity into the markets and economy. And that makes the inflation cycles much more difficult to predict.

The Wildcard: The Fed

There are smart people on the Federal Reserve Board.

The people at the Fed know that the financial system has become dependent on the easy money policies instituted over the past 13 years.

And they know that if they start to reduce the amount of liquidity they are injecting into the markets that they will lose control of both the narrative of financial stability and the upward support of asset prices.

Let’s look at a couple charts that shows results of the Fed’s actions.

First is a chart of the Fed’s balance sheet versus the S&P 500 Index, courtesy of Lance Roberts of Real Investment Advice.

Fed Balance sheet versus the S&P 500 index. Stocks are highly correlated with the Fed's actions.

It doesn’t take a professional statistician to see that there is a correlation between how much money the Fed is printing and stock prices.

This chart is all over the investment industry, and the Fed certainly knows of this correlation as well.

Former Fed Chair Ben Bernanke said back in 2010 that stock prices were a way to deliver confidence into the economy. Read it HERE.

Ever since then, the Fed has viewed their role as the driver of stock prices.

But why would increasing liquidity support stock prices?

Simple…it increases valuations.

The next chart, courtesy of Bloomberg, shows an even higher correlation between the Fed and stocks. And it shows the REASON why stocks prices have gone up with the Fed balance sheet.

This chart shows the Fed’s balance sheet versus the P/E ratio of the S&P 500. P/E ratios are the most common way to show valuations in the stock market by taking the price per share of a company’s stock and dividing it by the earnings per share.

Fed balance sheet causes stock valuations to increase.

This chart is much more in sync than the first chart. For example, in the chart above of the Fed vs the S&P 500 Index, there was a period between 2017 and 2019 where the Fed’s balance sheet declined, but stock prices rose.

When we look at the chart of valuations, we can see that between 2017 and 2019 valuations actually declined as prices rose. Valuations reflected the reduction of the Fed balance sheet while prices kept moving higher.

The secret to the Fed’s ability to impact stock prices, it seems, is by increasing valuations.

The primary way valuations are affected is by investor sentiment.

So what this really tells us is that the Fed is driving investor behavior by flooding the market with trillions of dollars of liquidity.

Exactly like Mr. Bernanke said.

And here lies the problem.

The Fed needs to pump the markets with so much liquidity that the economy becomes so strong that stocks will remain stable even if they stop asset purchases. God forbid they actually go so far as reducing their balance sheet.

More accurately, the Fed needs to pump so much liquidity into the market that they generate so much CONFIDENCE in the economy that the Fed can taper without crashing the system.

So far it is working.

Markets have become dependent on the Fed to keep prices afloat. They expect it.

If the Fed tells the market that they will raise rates in two years, it is similar to telling a drug addict that they are going to rehab in a couple months.

What would that addict do? They would binge on everything they could get their hands on and roll into Betty Ford in a stupor.

That’s what we’re witnessing in financial markets. Risk taking is everywhere. Assets of all types have been sought after. Prices across the board have gone up. We’re in an environment where even fake digital assets with dog memes are being coveted.

This speculative attitude towards risk could contribute to a massive rally over the coming months or years. Similar to the tech mania in the late 1990’s. Unbridled speculation would lead to one final blow-off top that puts a cherry on top of the bull market. Chef’s kiss.

Unfortunately, the same support of massive risk taking today is laying the groundwork of the volatility that will follow.

The Fed knows this as well.

Thus, they are stuck.

Do they rip off the Band-Aid now and stop the party? Or do they continue to support the craziness?

It comes down to one thing: they don’t want the party to stop on their watch.

It is easy to criticize from the outside. But no one wants to be in charge when it comes crashing down.

And that’s what we’re dealing with.

No matter how well-intentioned the people at the Fed may be, they are still human too. And they don’t want to go down in history as presiding over the end of the golden era of speculation investing.

So we’re likely to continue on the current path until someone is forced into action.

And inflation is the likely culprit.

The Fed will likely change the narrative before they start to tighten. They will start to blame something other than their own policies. They will blame bottlenecks or China or Congress or us. Anything but their own policies.

And that’s when we’ll know the cycle is truly changing.

When the consequences of the Fed’s actions are eventually felt, Henry Ford’s quote in the beginning of this report will most likely prove significant. For there is likely to be a backlash against the Fed for the reckless behavior and influence.

Until then, we must be prepared for volatility, but we must be prepared for an out-of-control stock market first. And out-of-control markets can be a lot of fun.

But now is not the time for complacency. And it is not the time to be stubbornly bullish or bearish.

Now is the time to be stoic. Be completely in tune and at peace with reality. When investing, that’s a good state of mind to be in anyways.

We can’t unstick the Fed. But we can try to navigate the consequences of their actions, whether good or bad.

Invest wisely!

The First Wave of Inflation is Receding

Waves recede in the sunset, similar to how the first wave of inflation is receding.

Last month we wrote in our Insights report “The Coming Inflation Waves” that we should not expect inflation to come at us all at once. Instead, we should expect it to come in waves.

Well, it looks like the first wave is starting to subside.

Lumber prices were one of the most common data points when the topic of inflation was discussed. Rightfully so…it went up nearly four-fold from 2020 into early 2021.

The chart below shows just how dramatic the price movements have been.

Lumber prices were up four times from the COVID low, and have now fallen 50% from their highs. Signs of inflation acting in waves.

This is exactly what we are talking about when we discuss the “waves” of inflation that we will likely see. Two steps forward and one step back will likely be the continuing pattern of price movements for inflationary assets like lumber over the coming years.

However, all inflationary assets will not move exactly in tandem. There will be ebbs and flows all around global markets.

But it is easy to see just how fast inflation can both make its presence known and recede and fall in price.

These types of price movements are the perfect conditions for investment mistakes. Make sure you stick to a disciplined process that adjusts to the changing landscape. Do not stubbornly buy and hold, but do not subject yourself to the emotional roller coaster of big price movements either.

This type of volatility lends itself to opportunities if handled correctly. But it also is full of risks for those not prepared.

Gas Prices Signal both Post-COVID norm and Inflation

Man's hand holding three hundred US dollars and gas nozzle while pumping gas into parked vehicle

Over Memorial Day weekend, gasoline prices hit the highest for this holiday weekend since 2014.1

With the Colonial Pipeline outage in the rear-view mirror and an ever-increasing number of adults vaccinated, formerly cooped-up motorists made the most of what America has to offer. The average price jumped to $3.04 per gallon ($1.08 higher than last year’s lockdown prices) and oil prices have continued to demonstrate high demand in the week following. The Wall Street Journal noted a two-year peak on June 1, indicating prices exceeding 2019’s records.1,2

It’s not just prices at the pump that are increasing.

Crude oil, as shown in the chart below, is also showing a strong recovery from last year’s lows. This chart dates back to 2003, and shows just how high prices were in the early 2010’s.

Crude oil downtrend has been broken. A new trend higher has begun? Inflationary pressures are mounting.

The rise in prices signal two things:

  1. Inflation is coming back. We discussed this in our report last month titled “The Coming Inflation Wave(s)“.
  2. Post-COVID life is returning. These new peaks are a sure sign that things in America are returning to something like a pre-COVID normal. While there’s still a way to go, these indicators point to something like the world we once knew.

While we’ll all miss the cheaper prices at the gas pump, it stands to reason that as we begin to emerge from this unprecedented period, that there’s a summer out there to be enjoyed. You might be taking advantage of the weather, but we’re still working for you. Let me know if you have any questions about these developments and how they might affect your financial strategy.

1. CNBC.com, May 27, 2021
2. Wall Street Journal, June 1, 2021
The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation. This material was developed and produced by FMG Suite to provide information on a topic that may be of interest. FMG Suite, LLC, is not affiliated with the named representative, broker-dealer, state- or SEC-registered investment advisory firm. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security.

The Coming Inflation Waves

Symbolic waves of inflation could crash the US economy, but only after years of a gradual increase.

Inflationary pressures have been steadily building over the past year. That can easily be seen in the price of lumber, residential houses and various raw materials. Recent data showed that CPI increased a whopping 4.2%. What implications does this have on your portfolio?

The first panacea for a mismanaged country is monetary inflation. The second one is war.

Ernest Hemingway

There is no question that we have seen massive inflation in various parts of the US economy since the end of the COVID-related market crash last year.

Homes in Austin are regularly being offered 20-30% above list price. The price of lumber has quadrupled over the past year. Used car prices are at all-time highs.

Some of the side effects of an inflationary environment are fairly obvious. Prices at the grocery store will go up. Gas prices will go up. Generally speaking, the cost of all kinds of “stuff” will rise. After all, that is what inflation is.

But there are other, less obvious things that are likely to happen during the period of rising inflation and interest rates that we have likely already entered.

There are two that we think are of primary importance:

  1. Non-linear price and interest rate increases.
  2. Dispersion in asset returns.

Both of these characteristics are critical to understand the investing environment over the next 20 years.

The non-linearity of the coming inflationary cycle simply means that it isn’t likely to hit us all at once. It will likely come in waves. We don’t need to know the exact timing and duration of each wave to properly navigate the next “rising” environment. We simply must be aware that it won’t come out of nowhere…there will be plenty of signs, many of which we’re seeing now.

We’ll go into more about dispersion below, but let’s first look at the historical cycle of rising interest rates to better understand what to expect.

The Interest Rate Cycle

Everything works in cycles. The Earth circles the sun. The seasons regularly change. Humans are born, age and decline.

Interest rates are no different.

In fact, interest rates typically rise and fall on a 60-year cycle. That’s a 30-year cycle of rising interest rates, and a 30-year cycle of declining rates.

The chart below, from Tom McClellan of McClellan Financial Publications, is one of the best examples we’ve seen that shows this cycle in action.

The 60-year cycle of interest rates going back to the mid-1700s. Yields consistently move in 30-year cycles up and down.

This chart goes back to the mid 1700’s. We can fairly easily see the regular rise and fall of rates over this period of time. With the exception of a few wars here and there that artificially affected interest rates, the 30-year rhythm plays out pretty well.

The current period of declining interest rates began in the early 1980’s. Inflation peaked at 14.3% in 1980. Interest rates peaked in June of 1981, with the prime rate at an incredible 21.5%. Many of you reading this likely had mortgages at 13% and 14% at the time.

Paul Volcker, the chairman of the Federal Reserve at the time, famously declared a war on inflation and took steps to “pop” the inflation bubble. And he was ridiculed for it at the time.

Since then, however, inflation and interest rates have been on a steady decline, as we can see on the “Black Diamond” ski slope downward on the right-side of the interest rate chart above.

But interest rates began declining in 1980. It’s 2021. We’re now 40 years into a 30-year cycle. We’re on borrowed time for when interest rates should be moving higher.

But what will this transition look like from a declining interest rate and inflation cycle to a rising one?

Slowly then Suddenly

One of the expectations right now is that inflation will hit us like a Mack truck. That’s a logical conclusion, given that lumber prices are four times higher than this time last year.

But this is a mistake that many people make when thinking about rising interest rates and inflation.

It doesn’t happen all at once, especially at the start.

Let’s look at the same interest rate cycle chart, but focus on the beginning stages of each rising cycle. There have been four major turning points in the last 260 years, as noted on the chart below.

The 60-year interest rate cycle with annotations showing the gradual increase in interest rates.

If we look at the red circles, interesting patterns starts to emerge. Rates don’t have any initial spikes higher at first. It takes time for long cycles like this to turn, much like steering a cruise ship.

In fact, we notice three distinct similarities in these periods of rising rates:

  1. In all four cycles it took 7-10 years for the first 1-2% rise in rates to occur.
  2. During this first 7-10 years, there are multiple “squiggles”, where rates take two steps forward and one step back. They ebb and flow like waves.
  3. Following the gradual rise, there is almost always a large spike higher in rates. Unfortunately, this has consistently been associated with a major, generational war.

If interest rates bottomed last year during the COVID crash, we are literally at the very beginning of this rise.

If the cycle of higher rates is indeed beginning now (which is our primary thesis), then we should still be a few years away from the period of rapidly rising rates.

But as with all things market-related today, the Fed is once again the wild card.

The Reckless Fed

We have discussed the Federal Reserve many times over the past few years. As recently as January in our “Twin Risks” report we discussed the possibility of Fed missteps. And last June’s “COVID vs the Fed“, we expected that the Fed would win when it came to rising asset prices, and that was indeed the case.

But even with improvements in economic conditions and the pandemic seeming to be much more under control with the highly effective vaccines, the Fed continues to print and print and print some more.

In our next chart below, we can see that the Fed balance sheet continues to expand dramatically.

The Federal Reserve (Fed) balance sheet as of May 2021 is almost $8 trillion. Courtesy of Bloomberg.

The spike higher in 2020 was the obvious and appropriate response to the COVID lockdowns. However, since late last year, the Fed has printed another $1 Trillion and force-fed it into the financial markets like a goose being primed for foie gras.

Last week alone the Fed printed nearly $100 Billion. All while the economy is obviously recovering and financial markets are at all-time highs.

During COVID, it was logical for the Fed to step in. Now? Frankly, it doesn’t make any sense.

It seems like we now have the first ingredients of a misstep. Continued massive monetary expansion WILL eventually have unintended consequences. What we don’t know is when the consequences will show up and what exactly those consequences will be.

The Fed is obviously signaling that it wants inflation. It is showing up all over the economy. Yet, the “official” inflation numbers are low.

Following the further injections of liquidity into the markets, pretty much every asset has risen in price (predictably). Some assets have risen more than others, but for the most part they all have gone up.

This simply can’t continue indefinitely. As Howard Markes says, “Trees don’t grow to the sky”. Everything works in cycles, especially asset prices.

And if everything works in cycles, and we are in a cycle where everything went up, what do we think might be next?

Well, it could be a cycle where everything goes down. But more likely it will be a cycle where instead of everything performing in unison, it could be a cycle where nothing performs in unison.

Which brings us to our second major theme for the coming decade: the return of dispersion.

What is Dispersion?

The official definition of dispersion, as it relates to our purposes here, is “the extent to which values of a variable differ from a fixed value such as the mean.” 1

Okay, so what does it mean in non-statistical terms?

It means that everything won’t go up at the same time.

It comes from the root word “disperse”. As when police officers instruct a crowd to go about their separate ways.

For our purposes, it means there will be areas of the financial markets that perform very well over the next 10-20 years, but there will also be many assets that decline in price as well.

In the definition above, the “values of a variable” simply mean different parts of the market. The “fixed value such as the mean” is the index.

So if the performance of S&P 500 is the “mean”, the underlying stocks and sectors within the market are the variables.

We would not be surprised if broad markets didn’t perform very well in the coming cycle. They could easily have flat or even negative returns over the next decade.

But that doesn’t mean you can’t make money. The “mean” is the average. But underlying that average are components that went up in price, and components that fell in price.

Since the early 1980’s, nearly every asset class has been in a bull market. Outside of the bear markets in 2000 and 2008 (and the COVID crash last year), stocks in general moved higher.

Guess what? So did bonds, commodities, homes, office buildings, international stocks, gold, and just about everything else on the planet as well.

Everything went up. The only difference was how much each investment went up.

And it makes sense that they all went up. As we noted earlier, both interest rates and inflation have been steadily declining since the early 80’s.

Declining interest rates almost always help asset prices go up. After all, many things are purchased with debt. Real estate is the most common use of debt to finance an acquisition, but debt is also used for all sorts of different financial activities. It is used to acquire companies, both large and small. And to build manufacturing facilities. And to purchase stocks. And to improve infrastructure. And to build high rises.

As interest rates fall, the cost of debt decreases. And that gives a purchaser the ability to buy more real estate, companies, manufacturing facilities, etc.

The opposite is also true.

As interest rates rise, the cost of debt increases. It takes away the purchasing power of everyone, from your new neighbor to the federal government.

This is why the Fed is so hell-bent on keeping interest rates low. And for a while now they have been successful.

But as we mentioned above, they can’t keep doing that forever. So we must start to think about what the next cycle may hold so we can make sense of the signals we may get from our investment process.

What Assets may Benefit from Rising Rates?

This is the $64,000 question. And if you’ve followed our reports at all, you probably know our answer. We have no idea.

While our investment process is designed to pick up on these changes over time, let’s look at some key characteristics of assets that could benefit from higher rates and inflation.

Pricing Power

In an inflationary environment, the costs of goods go up. That means that companies who are selling those goods are selling them at higher prices. Which naturally means that the revenue to these companies are also going up. Granted, input costs also rise, but if they can pass along higher prices to their consumers, it means they have pricing power.

Pricing power is critical to a company being able to successfully keep profit margins at current levels, and even being able to increase their margins. Without pricing power, companies have to increase efficiency or reduce costs to maintain profit margins.

Many companies will not be able to keep profit margins at current levels. The companies that can’t will likely have their stock price suffer.

The next chart shows that profit margins on the S&P 500 are at all-time highs.

S&P 500 profit margins have been increasing since the mid 1990's and as of May 2021 was at an all-time high.

As we discussed in our previous report “The Icarus Market“, we discussed how P/E ratios were elevated due to the increased concentration of technology stocks in the S&P 500 Index.

This also applies to profit margins.

Technology companies tend to have both higher profit margins and P/E ratios. So as technology becomes a larger portion of the index, profit margins should naturally increase.

To assume that profits margins can stay at these elevated levels seems like an optimistic assumption. And if they can’t stay at these levels, it is most likely due to tech not being able to keep pace.

Low Reliance on Debt

Another characteristic of a potentially good investment is a low reliance on debt.

As we discussed above, as interest rates rise, so does the cost of capital. Companies with lower debt loads, companies not dependent on financing activities to support their business, and recipients of higher interest rates could all benefit.

Banks are one area that may do well. Most banks make money off of a spread. They pay you nothing on your savings account, but charge you interest to take a loan. The difference in what they pay versus what they receive is called the “Net Interest Margin” or NIM.

As interest rates go up, their NIM should also go up. Because they are quicker to pass along higher rates to you as a lender than they are to you as a saver. Be prepared for continued frustration for a few years if you’re expecting the yield on your savings account to go up much.

But the big banks are turning into dinosaurs. There are many companies looking to disrupt this industry, so it may be areas in the financial sector outside of the behemoth banks that ultimately do well.

Other investments are much more dependent on debt. Real estate, for example, is one such asset.

Traditionally, real estate is expected to benefit from inflation. But it is also hurt by higher rates. So the dynamic between the inflation waves and the interest rate waves is key when it comes to housing prices.

We’re seeing home prices skyrocket now, partially due to demand, but also due to the fact that inflation is starting to appear, but higher interest rates are not.

So when inflation rises and interest rates stay low, home prices should continue to rise. But in our wave theory, there will be periods where inflation goes down and interest rates go up. That would not be favorable for real estate, and may provide opportunities to increase exposure to real estate.

This is exactly what we are talking about with the coming inflation and interest rate waves.

Stuff

The last area that may benefit is simply “stuff”. Commodities, materials, lumber, chemicals, and many other things that are used in real life things.

The reason these areas do well is the mindset of consumers during inflationary periods. The expectation is that what you are buying today is going to cost much more next year. So while it is more expensive than it was a year ago, it’s probably going to be more expensive next year. So you might as well buy it today.

As this mindset permeates the economy, the prices of stuff get more expensive. At first, higher prices tend to self-correct.

Earlier this month, the price of lumber fell 30% in a couple of weeks. It had gone up so much that people simply stopped building that new home. So prices corrected.

In this first inflation wave, this is expected. We also expect that it won’t get down anywhere close to the prices from last year. Prices will fall, and people will start to build again. And the next wave higher begins.

Alternate that same behavior over the coming years and we have the exact scenario we are describing…waves of inflation that gradually get higher over time. Until BANG! inflation is out of control, and we go into the steepening phase of the cycle.

Bottom Line

It simply appears that we have begun the next cycle of higher interest rates and inflation.

While it will likely take many years before it starts to get out of hand, there are easy ways to prepare yourself for this environment.

  1. Make sure any debt you have is at a fixed rate. Expect to pay more interest on new debt as time goes by. There is plenty of time to prepare, but now is the time to think about and prepare for higher rates.
  2. Dispersion favors active management. We’ll discuss this more in the future, but passive index investing and broad asset diversification is likely to be a poor choice in the coming market cycle. Your portfolio must become more focused.
  3. Re-evaluate your income strategy. Bonds are likely to be the worst performing asset over the coming years, unless we see an outright market collapse. You will need to be very tactical with your bond strategy. Cash rates will eventually move higher, but likely slower than we think.

In the immediate future, however, we should expect higher prices. Given that the Fed is still recklessly throwing gallons of gas on a market that’s on fire, higher prices should be expected in the near term.

But we think that this reckless behavior by central banks ultimately will be viewed in a very negative light. Primarily because of the skewed asset prices it is creating now. But while the party is still raging, more spiking of the punchbowl seems fun. And for now, it is still working.

But as this new phase of rising inflation starts to take hold, the Fed will likely find it more and more difficult to keep asset prices afloat.

That’s when the waves of inflation start becoming bigger and bigger until they simply can’t control it any more.

Our investment process was designed to handle any environment, including the ones that are most uncertain. Let us know if you would like to discuss this in more detail and how your portfolio may be affected.

Invest Wisely!

References:

  1. “Dispersion” definition from the Oxford English Dictionary online

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.

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!

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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.