Good news…this commentary is a wee bit shorter than the last. That was a marathon. Kudos to you if you made it through the entire thing. This one will be a bit more manageable.
What a difference a year can make. Last spring, my wife and I celebrated Easter with just our children in our home. I still remember my disappointment, that I wisely kept to myself, when I learned Easter family pictures would still be required. Getting a 3, 5, 7, and 9 year old to cooperate for photos is never easy and the process usually ends with someone in tears. Somehow, we managed through. Pictures were taken but soon erased as my daughter went on a crusade to remove any evidence that daddy had shaved his beard off during quarantine. Apparently, the site of my clean-shaven face while cycling through the photos on the iPad was just too traumatic for her. She even brought it up this year as she told my wife a couple weeks before Easter, “Last Easter wasn’t very good because Daddy shaved his beard off. I hope that doesn’t happen again.” Her wish was granted…things were more normal for us this year. Pictures were expected, we spent the day with our extended family, and my facial hair was in full bloom.
Similar stories are being told across the country as much of the nation continues to revert to normal life. More people are returning to offices, sporting events have spectators, restaurants are filling up, and summer vacation plans are being made. This activity translates is showing up in the economic numbers. Official GDP numbers for 2021 were not released at the time of this writing but the number is expected to be big. Massive government stimulus has effectively pushed the economy forward. If current estimates do continue to play out, the US economy will be “recovered,” (meaning, total GDP will be equal to pre-pandemic numbers) by sometime in the second quarter.
The stock market outpaced the economy, reaching the milestone of “recovered” late in 2020. It continued to grind higher during the first quarter of 2021, closing on March 31st near it’s all time high. Much of the reporting around corporate earnings seasons has been positive. Companies are optimistic about the recovery and believe revenues will continue to increase over the next year as the consumer becomes more active and the government continues to support the economy through stimulus. From some perspectives, things look bright for the immediate future.
The market is not without risks. Valuations across the US financial markets have returned to their pre-pandemic high water marks by almost every traditional valuation metric. By a price to earning measurement, the Nasdaq hasn’t been this expensive since just prior to the 1999 tech bubble. On a price to sales measurement, the S&P 500 is more expensive than at any other point ever. Professor Robert Schiller’s Cyclically Adjusted Price to Earnings ratio is at 37. That is a historical high surpassed only, again, by the Tech Bubble in 1999.
Beyond valuations, signs of excess continue to surface in various places as stimulus cash is looking for places to go. Special Purpose Acquisition Companies (SPAC’s) have attracted large amounts of capital the last 6 months. SPAC’s are shell companies that raise cash and then look for a company to purchase. Investors are gladly handing their money over to SPAC’s (there’s even a rap song about them…I kid not), despite having no clue what exactly they will be investing in. In another sign of excess, the price of cryptocurrencies has risen precipitously over the last 6 months. The long-term viability of crypto has somewhat solidified the last few years but the price appreciation may have gotten ahead of itself as some currencies have recently experienced price increases of 100% or more in just a matter of days. There are many other examples out there of money looking for places to go that we could site. Bottom line, there is a lot of money out there sloshing around and it sloshes indiscriminately. This will likely continue until something knocks the market off its tracks. When that happens, people will be a little choosier where their money goes.
Inflation may do the trick, as it appears to be mounting on the horizon. Material costs are in fact going up. The increase is extreme in some markets, such as lumber. These prices are starting to put pressure on profit margins as the increase in material cost eats into the profit companies realize on the sale of their product. This kind of pressure at the corporate level can only last so long before companies begin passing the increased cost on to the consumer.
An uptick in inflation could spell trouble for the market. Initially, company earnings will be impaired before they shift the price increases to the consumer. But more importantly, inflation might cause the most damage for equities, because of the response it engenders from the Federal Reserve. Consider that one of the justifications for today’s high valuations on corporations is the lack of decent alternatives. As Buttonwood pointed out in the January 30th Economist, when valuations were at similar levels in the late 1990’s, the yield on inflation protected bonds (TIPS) was almost 4%. In contrast, on March 31st, 2021 the yield on 10 year TIPS was -.67%. Yes, that’s a negative symbol in front of the number. You are effectively paying the government to borrow your money. Not a proposition many are interested in (A side note here – money has been flowing into TIPS as of late because of inflation concerns. We are not convinced that’s the best hedge in this scenario. For one, the interest rate is negative so to make money, inflation must happen. Secondly, utilizing ETF’s and/or Mutual Funds to purchase TIPS mutes the inflation protection because of portfolio turnover. Lastly, it can be a highly illiquid market. We went window shopping for some TIPS the other day and there weren’t a lot to buy).
Interest rates impact value all the way up the chain. With Treasury Issues yielding nothing or next to nothing, investors are willing to pay more for equities. If inflation causes the Federal Reserve to raise interest rates, then fixed income instruments become more attractive. That would likely have a negative impact the price of equities. While rate increases may still be some time off, we should remember that the market tends to be forward thinking when it functions appropriately. If the market sees inflation ticking up, it may put pressure on prices, regardless of the current action of the Federal Reserve.
So, it appears we are stuck balancing on this fragile wave of stimulus induced growth, riding it higher and higher while trying not to fall off the increasingly steep back of the wave. While domestic markets are richly valued, factors such as positive momentum, increased stimulus measures and positive economic growth could continue to drive it higher still. In many ways, short term economics look good. Global economies will likely have a banner year and consumers have $2.5 trillion more in savings than they did prior to the pandemic. Maybe it could work. That said, a lot of what is being conducted right now is a grand experiment. While continued government stimulus and intervention make things look good in short-term, how it plays out in the long-term is unknown. Are we setting the nation up for greater long-term growth or are we creating an increasingly fragile system reliant on debt and government funding? Time will tell. We will continue to look for opportunities to invest capital at an acceptable level of risk.