Another hurricane may lie ahead in the markets as the setup going forward seems problematic. Global economic and corporate profit conditions have likely peaked, inflation will be sticky, taxes are rising, valuations are inflated and optimism reigns supreme.
During the month of August, the market made a record 12 intraday all-time highs. There have only been two other times in history that there were 11 intraday highs in a month – in August, 1987 (prior to the large market selloff two months later) and at the top of the Bull Market at the end of the Roaring Twenties in 1929.
Admitting mistakes is a difficult act.
Over the short term my ursine market view has been wrong footed – in large measure because of the excessive and fiscal and monetary stimulus geared towards reviving the domestic economy and turning around the jobs market. As well, corporations adapted and aggregate 2021 and 2022 industry profits were well ahead of where most – including me – expected. Finally, market structure begot more equity inflows and FOMO (“fear of missing out”) emerged as an overriding emotion by many traders and investors.
In an honest assessment, Citi’s Tobias Levkovich deftly expanded on why bears were wrong over the last 12 months:
Where Have We Been Wrong?
Admitting to mistakes is hard but reviewing errors hopefully allows one to learn and avoid the same issues in the future. The two significant ones we made thus far into 2021 have been the powerful earnings that surprised most on the Street and the second is how effective the Fed has been in pushing investors towards risk assets including more than $500 billion into equity funds. With tapering on the come and EPS trends poised to slow, we suspect that these items may not be drivers going forward and other factors including euphoric sentiment and stretched valuation become more impactful, offset to some degree by reinvigorated share repurchase programs. In our minds, the stock market needs to consolidate the past 18 months’ worth of gains and portfolio managers require more visibility into 2022 profits, particularly when facing the probability of higher corporate tax rates next year.
As we have noted in recent write-ups, bottom-up 2021 consensus estimates started the year at $167 and now sit above $200. The investment community appropriately was anticipating a very strong 2Q21 due to easy comps from pandemic-related shutdowns in 2020, but 1Q results beat forecasts by nearly $10 and 2Q came in about $9 above higher expectations. Hence, the S&P 500 has climbed roughly 20% ytd, commensurate with the revised (stronger) bottom line projections as few clients see the P/E ratio or price/sales metric as looking attractive. With our margin lead indicator still arguing for caution on this front, we foresee some challenges evolving with a number of companies, for instance, citing their inability to overcome surging freight costs.
Higher indices beget money flows as FOMO emerges. In many respects, chasing the tape captures sentiment well as greed is a powerful driver. We find it difficult to abandon our Panic/Euphoria Model given its impressive past predictive capabilities. Similarly, low Top-50 (by market cap) intra-stock correlation also provides insight, reflecting current overconfidence amongst fund managers in terms of their ability to trade names exclusively on idiosyncratic fundamentals, while overlooking macro overlays. Given the impact of fiscal stimulus, inflation, bond yields, etc., it is hard to assume that overarching top-down influences can be ignored.
Congressional action may prove more daunting. The $1.2 trillion physical infrastructure package and the $3.5 trillion human infrastructure legislation are not slam dunks. With no Republican support for higher taxes, the latter will require getting every Democrat on board and there are rifts between so called moderates and progressives that cannot be glossed over easily. Ultimately, we expect a scaled down version to pass, but even that is not assured with the Street likely to see some of these divisions come out in late September when both the Senate and the House are back. It almost seems that taxes go up if we get the added spending boost or potentially there are no tax hikes alongside less increment to 2022 GDP.
We fully recognize that the market is 10%+ above our year-end target and even exceeds our mid-2022 outlook at this juncture, but capitulating against our disciplines seems incongruous. If our numbers are too low for next year, 20x P/Es still are unsustainable in our view even if inflation is not rampant. In the past, 0%-3% inflation was accompanied by 18x multiples and we are uncomfortable arguing new paradigm perspectives can justify extended valuation.
Of course these observations tell us why and where we have been and not where we are going.
“Investment wisdom is always 20/20 when viewed in the rear view mirror.”
– Warren Buffett
I feel strongly that there will ultimately be adverse consequences from the monetary and fiscal policies that were employed to get us where we are today.
This missive is an expression of charts that goes thru the key reasons I hold on to this point of view.
As seen in the chart below, an unprecedented 43% of GDP has been committed (including COVID-19 relief) to stimulate economic growth compared to only 6% in the 2009 Recovery and Reinvestment Act following the financial crisis and to spending 40% of GDP in the New Deal:
Despite a strong U.S. economic rebound and persistent inflation, central bankers have continued to maintain an extremely dovish stance – producing the loosest financial conditions in decades:
The U.S. money supply has increased by about 40% in the last two years, the most rapid 2-year rise ever:
COVID-19 and the need for emergency support for the U.S. economy has led to massive dislocations – most evident in the supply disruptions to goods, service and the labor market. Importantly, the pandemic has accelerated the trend away from globalization toward isolationism suggesting that the local and global supply chains are unlikely to mend anytime soon – placing even more inflationary pressures on consumers and corporations.
Large fiscal outlays combined with aggressive monetary stimulation have served to encourage speculation and have dangerously elevated the value of financial assets. The massive dose of central bank liquidity has correlated directly with the performance of the markets’ large technology stock leadership (FAANG plus Microsoft):
This week “FANGMAN’s” market cap hit $10.3 trillion – up from less than $5 trillion in March, 2020.
The five largest market caps represent over 10% of the S&P and over 20% of the Nasdaq.
Short interest is at all-time lows – providing an inconsequential buffer if stocks fall:
The monetary backdrop has also contributed to a widening, record and worrisome gap between the S&P Index and after tax corporate profits:
With the burst of liquidity, the S&P Index’s forward price/sales ratio has climbed to another record high. The ratio is now at levels that have historically resulted in meaningful stock market corrections:
In addition, an adverse policy outcome has been soaring headline and pipeline U.S. inflation which is unlikely to vanish quickly. Home prices have risen by nearly +20% (year over year) and, in the last six months, the annualized rate of CPI inflation was +7.8% while core inflation has risen by +6.8%:
Rising inflation has become a global phenomenon:
Reflecting my expectation that inflationary pressures will stubbornly persist, I expect a Fed pivot in the months ahead.
History demonstrates that stocks tend to struggle during Fed balance sheet contractions:
History has also demonstrated that adverse outcomes come out of obstreperous policies.
I am convinced that the most undisciplined fiscal and monetary policies ever will have more untoward economic (and market) implications. Most notably, there is already accumulating evidence that the U.S. economy is moving towards stagflation.
As recently noted by Peter Boockvar, the release of the August Dallas Manufacturing Index supports some of our stagflation concerns. The Index fell to 9 from 27.3 and the six month outlook slumped to 15.1 from 37.1, the lowest since July 2020. Consider some of the selected company and industry comments that were contained in the report:
Machinery Manufacturing: “This is the worst market I have seen since 1975… We see variations in sales from month to month that are hard to explain. Sales are up one month and then down the next. We would prefer a steady flow of business so that we can plan accordingly. Strange times we live in!”
Transportation Equipment Manufacturing: “Labor costs continue to rise, and supply chain disruptions with major material components continue to drive production delays, increased costs and uncertainty… Today, the business demand is encouraging, but there are too many future uncertainties, ie, inflation, available employees and the economic outlook, including continued supply chain problems and the fact that Covid won’t go away. Add a dysfunctional government and runaway fiscal spending and it’s hard to be optimistic. We are proceeding cautiously.”
Furniture and Related Product Manufacturing: “We continue to have unfilled employee positions, and the labor rate is increasing at a faster pace than our product pricing.”
Paper Manufacturing: “It is impossible to find employees. We are having to work the ones we have way too hard.”
Printing and Related Support Activities: “We are worried about how rampant inflation is for our materials and services and feel the economy is in for a jolt soon on this front. Because of this, we are worried about 6 months out, although we are busy now and appear to be busy for a while to come.”
Already, Citigroup’s Economic Surprise Index has turned negative.
Persistently high inflation, continued supply bottlenecks, the unwillingness of companies to increase inventories in the fact of the Delta variant, emerging economic weakness in China, peaking consumption, fiscal cliffs and geopolitical risks suggest the rate of global economic and profit growth peaked a few months ago and will likely begin falling dramatically over the balance of the year:
Global PMIs have flattened out and have begun to turn lower:
In the fullness of time, I feel all of these factors discussed could negatively impact market valuations. What could make matters worse is that these policies are being extended at a time in which our country’s debt load is at an all-time high and when valuations are extremely elevated.
That said and as previously noted, the markets are currently in full disagreement with my views.
As stated, massive doses of liquidity remain the principal cause of higher stock prices.
Another proximate cause is the markets’ changing structure over the last decade away from active management and towards passive investing. Quant Strategies and ETFs – so entwined and dominated by machines and algorithms which pursue price momentum over value investing – have contributed to the ungiving rise in stock prices which have fed upon itself in recent months. While these strategies know everything about price, they know little about value. They have reinforced a virtuous market cycle characterized by limited market corrections.
As mentioned in my Diary, most historical valuation metrics, with the exception of stock prices relative to interest rates, are dramatically elevated – indicative, to us, that the market is materially underpricing risk.
Low interest rates provide the roots for historically high valuations, but as Oxford Economics’ Adam Slater points out, a core issue with the TINA argument is that there’s “a fundamental problem with the low rates argument – that we may be comparing one overvalued asset class with another.”
Warren Buffett’s favorite valuation barometer — total market capitalization to gross domestic product — is a glaring example of an overvalued stock market:
Global equities are now worth $118.6 trillion, the highest value ever in history and equivalent to a record 140% of world GDP:
“Did he doubt or did he try?
Answers aplenty in the bye and bye,
Talk about your plenty, talk about your ills,
One man gathers what another man spills.”
– The Grateful Dead, St. Stephen
My ursine market view is depicted in the charts and commentary contained in this (Thursday) opening missive.
Very few stocks meet my standards to purchase.
There is presently a miniscule “margin of safety.”
The market’s overall upside reward is materially dwarfed by the downside risk.
P.S. – Please watch this rendition of The Grateful Dead’s Ripple – it is inspiring.
(This commentary originally appeared on Real Money Pro on September 2. Click here to learn about this dynamic market information service for active traders and to receive Doug Kass’s Daily Diary and columns from Paul Price, Bret Jensen and others.)
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