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The 2022 Sell-Off: Making Sense of the Markets

The 2022 Sell-Off: Making Sense of the Markets

The market weakness in 2022 has continued to accelerate, driving equity prices lower. While it may feel like a pretty extreme selloff, the S&P 500 selling off 15% is fairly normal, occurring every 2.5 years. Even if we reach a “bear market”, defined as a 20% or more decline, this will occur on average every 4 years, so we are experiencing a phenomenon that is relatively frequent.

This, of course, doesn’t make anyone feel particularly better. As our revenue is tied to our clients’ assets under management and every advisor in our firm invests in the stock market in some form, we all feel the pain. There are many reasons for this. Inflation has run significantly above target levels. The Fed is moving away from ultra-low interest rate policies. And the war in Ukraine continues. These have all contributed to the uncertainty surrounding companies and their future outlook.

We have continued to watch earnings as they have been reported. Presently, they still are strong but earnings surprises have trended lower and future earnings are looking a bit more tenuous pending all the above uncertainty. This is not to say that we haven’t already hit the bottom of this pullback, nor is it saying that things can’t get worse. It is worth mentioning that today’s stock prices reflect the expectations of future earnings by companies. It is predictive in nature, and that’s why we have seen the results in 2022 when we look in a rearview mirror. An end to the Ukraine war, easing of inflation numbers, reduced COVID cases & lockdowns, and better news on supply chains could all be factors that will likely drive equity markets higher. A dive into a bear market could be caused by a worsening of any of the above as well, and that is precisely why we tend to advise caution in making any short-term decisions that can have long-term impacts.

Did you also know that the bond market is having its worst year since 1842(!!!)? Normally we see an inverse relationship between stocks and bonds, with bonds increasing in value while we see a negative stock market.

So, What to Do?

Assessing timeframes is obviously extremely important. Keep in mind that despite the pretty awful market we’ve seen so far this year, the longer-term returns look strong. Here’s a chart of the S&P 500 over the last five years:

Just from eyeballing the chart, you can also see that we’ve had some pretty feracious pullbacks before we hit higher highs. The difference between now and then? Inflation is running hot, and recent reports are showing that it is not coming down quickly.

What Can We Expect in the Future?

According to research by First Trust, out of the last 185 quarters, only 16 had stocks and bonds falling together. When we look back at historical data, returns tend to be positive in the stock and bond markets, especially in the 1- and 3-year periods. See this chart that lays out prior stock and bond market returns. While we know that the future is uncertain, we also know that it’s almost never about timing the market, it’s about time in the market.

Clint Walkner

The Year of Impossible Choices: 2022 Market Outlook and 2021 Review

The Year of Impossible Choices: 2022 Market Outlook and 2021 Review

In last year’s market outlook, I described the current state of global monetary policy as a giant exercise in price control, specifically, control of the cost of capital. An environment in which perpetually falling rates and equity premiums favor longer duration growth stocks, but hardly resulted in what might be described as widespread prosperity. 

The (short-lived) revenge of the bottom half

During the grand re-opening of 2021, for a brief moment, dare I say it, things seemed to be going well. Bolstered by massive government stimulus and a strong job market, something remarkable happened to the average American household: they got richer.

While household wealth rising is not surprising given equity, real estate, and cryptocurrency gains, what was truly remarkable was the relative gain attributable to the bottom 50% of American households, whose share of total wealth rose above 2.5% in Q3. While the percentage remains low in absolute terms, we had not seen this metric rise above 2% since the 2008 crisis, and 2.5% was last witnessed in the early 2000s.

A tight labor market, marked by the “great resignation” (an unusual number of people quitting their jobs), has certainly contributed to the slight, but noticeable, narrowing of inequalities. For the first time in years, the labor market appears to have shifted in favor of workers, who may be in a much stronger position to secure higher wages, strengthening their ability to accumulate wealth. Direct COVID relief payments and expended child credits also contributed to this continued improvement in household wealth.

Unfortunately, before anyone could celebrate a resurgence of the American middle class, a much bigger story would steal the headline: the return of inflation. In the short term, moderate levels of inflation can have a beneficial effect on the job market, support asset prices, ease debt burden, and even reduce income inequality. In the long term, however, the upside risk to inflation makes me less than enthusiastic about the potential for a continued trend in narrowing wealth inequalities. 

While higher inflation means that everyone, in aggregate, gets poorer, some might get hurt more than others. Over time, cost pressures are likely to favor owners of productive assets at the expense of small savers and wage earners. A recent analysis by the Penn Wharton Budget Model already highlights the increasing burden on middle-income family budgets, who spent about 7% more in 2021 for the same products they bought in 2020 or in 2019.

The era of low inflation never started, now it may be ending

The return of higher inflation, in the form of her CPI numbers, was heralded as a momentous shift in the economic environment in 2021. After all, inflation has not been a major concern in most of the developed world in the last decade, some have even suggested that we lived in the era of low inflation, and central bank action certainly focused on fighting the perceived threat of deflation first and foremost.

I was never a huge believer in the idea of a “low-inflation era.” To be sure, we may have had moderate levels of inflation on average, but more importantly, we’ve had an era of uneven, patchy inflation, where falling prices in some areas were offset but rapid increases in others. 

What charts like the one above highlight, is that the supposed low-inflation era has, in fact, been an era of selective inflation. An era in which, broadly speaking, the price of things we don’t really need, like toys and electronics, has collapsed, but the price of things we need (say, food, housing, and healthcare…) has continued to rise. 

In this environment, it is perhaps no surprise that middle-class households hardly seemed to reap the benefits of low prices. All else being equal, and despite the prevailing inflationist narrative: no inflation is good, deflation is even better (how often have you complained about prices at the store being too low?). For two decades deflation has been limited to a relatively small segment of largely discretionary expenses, while higher costs in other products may have actually reinforced inequalities.  

Regardless of how the Consumer Price Index is composed, it is also important to recognize the limitation of the CPI (our policy makers’ main tool in measuring inflation). CPI is a complex set of data maintained by the Bureau of Labor Statistics. Over the years, its methodology has been revised multiple times, and most recent adjustments have tended, in my opinion, to make monetary policy look better. Some of the most convenient CPI adjustments include: substitutions (the idea that if something is too expensive, we’ll just buy something else, say lemons instead of bananas…) or, even better: hedonics (an adjustment made when a price increase isn’t actually deemed to be a price increase, but just a reflection of improved product features). Not to mention the fact that shelter, one of the largest components of CPI, is for the most part not collected using a market-based mechanism. Instead, most of the CPI’s shelter data comes from something called Owner Equivalent Rent (OER). OER is basically a survey of homeowners, who get asked a simple question about how much they think their property could be rented for (imagine calling your parents who’ve lived in their house since 1976, and asking them what they think the rent is). 

Regardless of how much I doubt inflation numbers, what became obvious in 2021 is that no amount of adjustments could make inflation look benign. Since March 2021, CPI inflation started exceeding the Federal Reserve’s 2% target and has continued to rise ever since.

In August 2020, the Federal Reserve implemented a new flexible approach to inflation, effectively warning the market that it may allow inflation to “run hot” for a while if it deemed necessary. We are now in our ninth month of excess inflation, and just how much more of these inflation numbers will be tolerated is unclear. 

Over the last few years, central bank officials have often felt the subtle (or not so subtle) pressure to keep their policy stance accommodative (remember Donald Trump praising Janet Yellen for being a “low-interest person?). But politicians and the general public can be fickle, and the pressure to remain accommodative can just as easily morph into a pressure to tighten. If inflation continues to take hold, being a low-interest rate kind of person may not look so flattering anymore.

The trillion-dollar checking account

I have long been telling clients that the pandemic could, somewhat counterintuitively, be the catalyst for higher inflation. By pushing governments and central banks to implement a combination of both extremely loose monetary and fiscal policy, they may just have poured fuel on a fire that had been simmering for years underneath the low CPI numbers. While 2020 saw unprecedented levels of new debt issuance and stimulus, a lot of promises only reached full implementation in 2021, which may explain the sudden, but somewhat delayed, change in inflation dynamics. 

The U.S. Department of Treasury’s general account with the Federal Reserve (effectively, the government’s checking account) spent most of 2020 swelling up to unprecedented levels: normally fairly steady at a balance of around $300 billion, it reached a balance of $1.8 trillion in mid-2020 at the height of the pandemic.

In contrast, 2021 was truly the year of the great spending spree, when checks were finally cashed, even as treasury bill issuance slowed. $1.6 trillion was promptly spent in a matter of months between February and July 2021. As Citi’s market strategist Matt King highlighted back in February 2021: the flood of cash created by the drawdown in the treasury’s general account (TGA) risked tripling the amount of bank reserves, and pushing rates even further towards zero or negative territory: “surfeit of liquidity and a lack of places to put it – hence the rally in short-rates to almost zero, with the risk of their going negative.” As King further notes, “if relative ‘real’, inflation-adjusted Treasury yields fall, it could weaken the dollar sharply (…) at the global level the TGA effect will indeed prove highly significant.

As shown above, real yield would indeed fall throughout 2021, to levels unprecedented in modern history, and one of the side effects of negative real yield may have been to propel the now-familiar “risk on” investment theme to new heights. We all thought money was cheap at -1% real rates in February, how about -6.5% In November? 

The treasury department wasn’t the only one spending. As it turns out, American households too were fast and loose with their checkbooks. Individual savings rates had risen during the pandemic and remained relatively elevated well into the beginning of 2021. Since March 2021 however, saving rates have fallen back to their pre-COVID levels.

Against this backdrop, it is perhaps no surprise that the “buy everything” ethos, long limited only to financial assets, now seems to have spread into housing, commodities, energy, various consumption goods, and even used cars.

With gains of nearly 50% since December 2020, the Manheim Used Vehicle index outperformed both the S&P 500 and the Dow Jones in 2021.

Impossible choices

Over the last decade, central bankers have been almost entirely focused on supporting the economy. With the threat of inflation only a distant concern, there has been basically no downside to perpetually flooding markets with free money. To be sure, central bankers have been fairly successful in averting deflationary fears and consistently driving down real (inflation-adjusted) rates. With short-term rates at zero and longer-dated bonds at historic lows, many observers felt that yields had nowhere else to go. Real, inflation-adjusted rates have no such lower bound. And as much of what the recent spike in inflation will be heralded as a change of regime, in many ways, it can also be seen as the culmination of a broader trend in lower real rates that started many years ago – and arguably as far back as the mid-80s.

With real yield deeply negative, and central bank balance sheets at all-time highs, 2021 brought the scale of global monetary policy to yet another record-breaking year. However, for the first time in over a decade, inflation may truly force central banking officials to tighten policy this time. So far, policy response in the U.S. has been mainly limited to tougher talk and a planned reduction of the pace of asset purchases (the now-famous “tapering”). While FOMC guidance does indicate an expectation of multiple rate hikes in 2022, the Federal Reserve will be walking a very fine line as it looks to change course.

One of the paradoxes of the current environment is the continued flattening of the yield curve. A flood of bank liquidity may have contributed to the collapse in real short-term rates but has not resulted in any real upward shift in long-dated bond yields. This could be interpreted in numerous ways. Perhaps the bond market is simply not buying the idea of long-term inflation or may think it raises the probability of a policy mistake (excessive tightening leading to a deflationary crisis), or perhaps the Federal Reserve’s bond-buying program has simply distorted bond prices to such a degree that rates no longer reflect any realistic growth and inflation expectations. Whatever the case may be, hiking rates in this environment would mean running the risk of yield curve inversion: a situation where short-term rates would exceed long-term rates. While not always predictive of a crisis, an inverted yield curve generally sends a very negative signal and isn’t consistent with a healthy economy, in which opportunity cost should correlate positively with time.

Central banking officials are very aware of the risk, and the issue of curve flatness was explicitly brought up by members of the FOMC in their December meeting. There is a certain common-sense logic to the idea that, before resorting to traditional monetary tightening policies (raising short-term rates) the Federal Reserve should first get rid of the more exotic, experimental, crisis-time measures, such as quantitative easing. Doing so may allow long-term interest rates to rise, resulting in a more constructive environment in which to hike short-term rates. After all, if the economy is strong, to the point of raising rates, why have QE at all? That does not seem to be what committee members are thinking. In fact, according to their latest minutes, they seem intent on doing the exact opposite: begin to raise rates as early as March 2022, and then tackle balance sheet reduction. Even so, balance sheet reduction would not resemble a complete termination of their bond-buying program, but would probably involve a monthly cap on the amounts of “runoffs” (treasury bonds allowed to mature without being reinvested). Assuming that the monthly cap on runoffs does not exceed monthly maturities, the net effect of this policy may be that the Federal Reserve will be continuing to buy billions of dollars worth of bonds every month for the foreseeable future. Presumably with the hope that slowing the pace of balance sheet reduction will act as a buffer against the possible negative effects of rate hikes. 

In this balancing act between tapering and rate hikes, one might perhaps perceive a subtle acknowledgment that central bank officials have made themselves into de-facto custodians of stock prices. After all, their previous attempts at an interest rate hike cycle in 2018 ended in a 20% market sell-off and had to be promptly reversed. At today’s valuations, a similar sell-off would wipe out nearly 10 trillion dollars of value from the S&P 500 alone. Ultimately, the message buried in the complex mix of central banking rhetoric may simply be that the Federal Reserve intends to stay behind the curve in its attempts to tackle inflation. That it intends to tighten policy slowly, while remaining accommodative and relying on the magic of negative real rates to support asset prices and the economy, tightening without tightening. Exactly how long they can get away with this in the face of higher inflation is anyone’s guess. Given the huge political stakes around issues of wealth inequalities, and with midterm elections around the corner, I expect pressure on the Federal Reserve to ramp up over the coming months. Backed into a corner, central banking officials may just have to pick between continuing to support market valuations and curbing cost pressures. However things turn out, 2022 may very well be the year when investors and US households alike realize that free money does have a cost after all.

Syl Michelin, CFA

2022 Investment & Market Outlook Guide

Syl Michelin’s piece is part of Walkner Condon’s 2022 Investment & Market Outlook Guide, a comprehensive reflection of 2021 and glimpse at the factors impacting the year ahead in 2022.

2022 Investment and Market Outlook Guide

2022 Investment and Market Outlook Guide

Walkner Condon’s team of experienced financial advisors explores key topics that are top-of-mind as we transition out of 2021 and into a new calendar year, featuring the market outlook and review from Syl Michelin, a Chartered Financial Analyst™. Other topics include index funds, sector & factor performance, a pair of U.S. expat-focused pieces, and more.

Below you can find a breakdown of the individual pieces in this year’s outlook. 

1. The Year of Impossible Choices: 2021 Market Recap & 2022 Outlook
Syl Michelin, Chartered Financial Analyst™

Through a lens of current and historical data, Walkner Condon’s resident CFA® explores the last year in the markets, with an eye on factors that may impact 2022. 

2. It Only Gets Harder from Here: Valuations, Bond Environment & Wage Growth
Clint Walkner

With a multitude of market highs throughout 2021 and a long stretch of gains post-2008 financial crisis, it would appear the “easy” money, if we can call it that, has been made. In this piece, Clint dives into the three main challenges as we move forward into 2022.

3. Reviewing 2021 Sector and Factor Performance and Positioning in 2022
Mitch DeWitt, CFP®, MBA

The markets were up routinely throughout 2021, but that doesn’t mean the gains were shared equally. Mitch discusses the sector winners (and losers) of the last year, along with what factors – things like high beta, value, and quality – had their day in the sun. He also goes into what might be on the horizon this year.  

4. Exploring Index Funds: History, Construction, Weightings & Factors
Nate Condon

The goal of this piece from Nate is to provide a general overview of indexes, the differences in how indexes are constructed, including equal-weighted indexes versus market capitalization-weighted indexes, and passive and factor indexing strategies.

5. Three Reasons to Look at Investing Internationally in 2022
Keith Poniewaz, Ph.D.

Though the U.S. dollar had its best year since 2015 in 2021, Keith explains several reasons to think about international investments in 2022, including the very strength of that U.S. dollar, valuations, and the rest of the world’s growth in GDP.  

6. Top Five International Destinations for U.S. Expats in 2022
Stan Farmer, CFP®, J.D.

One of our U.S. expat experts, Stan jumps headfirst into possible locations for Americans to consider in 2022 if they’re thinking about a move abroad – or even if they’re just wanting to dream a little bit. Stan covers ground in South America, Europe, and Asia in this thorough piece, perhaps his first crack at being a travel journalist in his spare time. 

QE & Adventures in a Fed-Driven Market: 2020 Market Recap and 2021 Outlook

QE & Adventures in a Fed-Driven Market: 2020 Market Recap and 2021 Outlook

Technically, the record-breaking bull market that started in 2009 ended in 2020. I say “technically” because the sell-off was so short-lived that it almost didn’t feel like a true bear market, and the rebound was so sharp that it didn’t feel like a proper recovery. As we continue to emerge from the Q1 shock, our new bull market sure feels a lot like the continuation of the previous decade-long uptrend, with the same drivers (low rates, central bank intervention) and the same dominant sectors (with big tech leading the way). 

Last year’s events left many investors with a feeling of unease at the disconnect between the economy and the market. Many were already skeptical about valuations prior to COVID. When a brief collapse was immediately followed by a moon-shot to unthinkable new highs, investor skepticism rose along with it. This is perhaps the most common point of concern for our clients: how can weak economies, with falling demand and rising unemployment, justify higher equity prices? When faced with this question, I’ve often tried to draw our clients’ attention to the prodigious scale of the monetary measures being implemented, and to the fact that the link between markets and the economy isn’t always as direct and linear as many investors expect, as we will discuss later. 

One way or another, it’s largely been about the Federal Reserve and their international counterparts (ECB, BOJ…), and while 2020 will probably be remembered as the year when everything changed, as far as markets are concerned, we seem to be trapped in the same powerful dynamics that were in place a year ago, and which have become even more deeply entrenched as a result of the pandemic.

Fun With Trillions

At the beginning of 2020, many observers would have described global monetary policy as extremely loose, historically so. Part of the bearish narrative was that central banks had run out of ammunition: with both ECB and Federal Reserve balance sheets hovering around all-time highs, and interest rates near zero, surely there wasn’t much left for central banks to do. 

As it turns out, they were just warming up. 

Keeping up with monetary policy and high-flying government finance requires a rare skill: the ability to make sense of large — very large — numbers. Can anyone really wrap their minds around numbers like 665,900,000,000,000 — or 666.9 trillion — the approximate size of the Bank of Japan’s balance sheet in Yen? 

Central bankers and politicians seem to deal only in rounded trillions nowadays: the first COVID relief bill was 2 trillion dollars, the ECB expanded its Quantitative Easing (QE) program in June by 1.3 trillion Euros, and so on…and with every new trillion-dollar headline, the world of big finance grows increasingly disconnected from reality, almost like it exists in its own parallel universe. 

Trying to relate the idea of trillions of dollars to something tangible would look something like this: if you had 1 million dollars in a compact stack of 1,000 dollar bills, the stack would be approximately 4 inches in height. A million is a lot of money by any standard, yet it’s small enough to carry in a handbag. To get to a billion dollars, the stack of 1,000 dollar bills would have to grow to about 358 feet, or about 50 feet higher than the Statue of Liberty. To get to a trillion, the stack would need to grow to a length of approximately 67.9 miles. (1)

Central bankers don’t need to worry about the logistics involved in printing and shipping 70-mile long stacks of bills, they save themselves the hassle by creating currencies in electronic form, but the impact on markets of their various trillion-dollar endeavors are just as real. 

To understand why 2020 was truly the year of “Fun with Trillions”, consider the following chart:

The main global central banks have added nearly 8 trillion dollars to their combined balance sheet in 2020 alone. Source: Atlantic Council global QE tracker

The Federal Reserve added 3.2 trillion dollars to its balance sheet in 2020 alone, more than it did in the entire 2009 to 2019 period. Source: fred.stlouisfed.org

Over 20% of the U.S. money supply (measured a Money of Zero Maturity) was created in 2020 alone. Source: fred.stlouisfed.org

So what does this all mean? Therein lies the issue for investors — we can observe trillions of dollars being (digitally) printed and hear about it on the news, but what does it mean for markets? How does that relate to the size of our 401k’s? Or Apple’s share price? What would today’s markets look like if QE had never existed?

One team of analysts at Société Générale did attempt to answer this thorny question. (2) Sophie Huynh and Charles De Boissezon, of the bank’s equity research group, used a regression analysis to estimate the impact of QE on treasury yield. They estimate it at about 180 basis points cumulatively since 2009 (in other words, without QE the 10-year yield would be close to 3%). They then used a dividend discount valuation model and the bank’s proprietary model for equity risk premiums (the excess return of equities of bonds) to derive a hypothetical valuation of stocks without QE. 

Their results are rather striking.

As shown above, the impact on stocks’ prices has been dramatic according to their model and even more pronounced in the NASDAQ than the S&P 500.

Overall, the bank’s model estimates that 44% of today’s S&P 500’s price level can be attributed to QE. In the tech-heavy NASDAQ, the percentage rises to 57%. The pace of change has not been linear, and 2020 saw a massive spike in the percentage of price level explained by QE.

We’ll never know how accurate this model truly is, but I believe it captures one fundamental truth about current market conditions, which is simply that QE changes everything. 

With the 10-year yield over 3%, and the S&P 500 at 2000, markets would certainly not be as exciting as they are today, but some might say that they would be a more honest reflection of the economy.

The eternal bullishness of a stagnant economy 

Whatever QE’s impact on the market might have been, it’s unclear whether it has benefited the economy in any meaningful, lasting ways. The pace of U.S. economic growth has generally been around 2% for nearly a decade until 2020.

Early forecasts indicate a decline in U.S. GDP of around 3.5% in 2020, though it’s expected to rebound in 2021. Meanwhile, corporate earnings have barely grown in the last few years, even as markets soared to all-time highs.

This environment of stagnant economies and earnings growth has prompted many to speculate that markets have risen too far, too fast, and these concerns are valid. After all, QE or not, one would expect economic realities to eventually catch up with markets. All else equal, slowing earnings growth should result in lower stock prices. With that being said, we must also keep in mind that the market and the economy are two distinct entities.

In a recent research piece, Vincent Deluard (StoneX’s head of macro research) makes a simple yet counter-intuitive point which I think helps capture a lot of today’s market dynamics. His view can be summarized as follows: in an environment of secular stagnation, where discount rates and growth decline, stock prices will soar. To understand his point, it helps to review some very basic concepts of equity valuation. 

Stocks are ultimately just claims on a future stream of cash flow, a dividend for example, or whatever might correspond to the liquidation value of a company. Any stream of future cash flow is valued by dividing the periodic cash flow by a discount rate, which accounts for the time value of money, and for risk. For example, a hypothetical annual payment of 10 dollars that lasts forever would be valued by simply dividing 10 by 5% (if we assumed a 5% discount rate): 10 / 0.05 = 200, so this perpetual cash flow of $10/year is worth $200 dollars today.

Equity valuation works in a very similar way, but the discount factor is slightly more elaborate. One example of a basic stock valuation model is the Gordon Growth Model, which works with the formula on the left.

This is conceptually very similar to our perpetual annuity example. The discount rate “r” can be thought of as the rate of return that investors require for the stock, the constant cost of equity capital. Because company earnings grow over time, “g” is added to account for growth, and reduces the discount rate, causing the value of the ratio to increase (the stock price to rise).

Going back to our example, imagine a company (let’s call it Stagnant Inc.) that pays a $10 annual dividend per share. Stagnant Inc’s share price could be valued as follows using the Gordon Growth Model:

10 / (0.10 – 0.5) = $200

In the above example, 0.10, or 10% is the “r”, the discount rate, the return investors expect, and 0.05 is the 5% growth of the company’s dividend. If we assume that Stagnant Inc.’s growth rate declines by 10% a year going forward, and that the expected rate of return “r” also declines by the same 10%, the stocks price over a 50 year period would like this:

In 50 years, Stagnant Inc.’s stock price soared from $200 to over $34,000, a gain of over 11% a year, all happening despite a steady decline in earnings growth. This is what Vincent Deluard refers to as “the crazy math of secular stagnation.” (3)

Source: Vincent Deluard, StoneX research, www.marketintel.stonex.com

As shown above, lower capital costs (discount rate) can justify higher valuations even in the face of dwindling earnings growth. As both growth and discount rates trend towards zero, prices rise to infinity.

This is perhaps what many investors have missed when constantly expecting markets to fall back to earth: while there truly is a disconnect between the economy and markets, there may also exist a causal link between economic weakness and higher stock prices, a self-reinforcing trend of perverse incentives where slow growth fuels market uptrend, where bad news for the economy can quite literally become good news for stocks, and markets may have been riding this stagnation boom for many years now. 

I would add that QE and central bank interventions are factors that will tend to affect expected returns over time. In markets, the cost of equity capital is mainly a function of interest rates, volatility, and risk premia. By keeping interest rates low and dampening volatility, central banks’ activity can really be thought of as one giant exercise in reducing expected returns. When the Federal Reserve announced that it would start buying high yield bond ETFs, the prices of these bonds quickly jumped. There is nothing irrational about this investor behavior. If a high yield bond had a yield of 6% prior to the Federal Reserve’s decision to step in, once the Fed enters the fray, investors were happy to accept a lower yield, maybe 5%, simply because they knew the Fed would step in to support prices as needed. Equities work the same way. In a world where any weakness or volatility is met with the immediate expansion of the Fed’s balance sheet and trillions in government intervention, you would expect equity investors to feel more comfortable and adjust their risk appetite. For example, a stock that an investor would have normally considered too risky to buy (perhaps a high-octane IPO), can suddenly become a very justifiable acquisition once the Fed’s de-facto pledge to support markets is factored in. Coincidentally, more IPOs have doubled in price in 2020 than any year since the tech bubble. (4)

This reasoning can be pushed even further to explain some of the current sector dynamics: in a world of constantly falling cost of capital, equity valuation becomes disproportionately affected by cash flow duration. To draw a parallel from the bond world, if we knew that rates were going to consistently decline, we would naturally look to buy the longest-dated bonds (maybe a 20+ year treasury). Likewise, if the equity cost of capital is constantly falling, winning the equity valuation race becomes a game of who can extend cash flow duration the furthest into the future. 

This may at least partially explain why today’s dominant stocks are to be found in the tech world. As highlighted in StoneX’s report, U.S. tech giants, with their low payout ratios, low book values, and future-proof product lines, can be thought of as the equity equivalent of a very long-dated bond and will benefit the most from the falling cost of capital. The SocGen report referenced earlier also highlighted that the tech sector’s outsized benefit from QE for similar reasons. 

In the game of ever-increasing cash flow duration, current earnings and profitability are secondary to future cash flows. Any company with a semblance of growth enters the race to a near zero-value denominator and is disproportionately favored by investors. Similarly to how aggressive bond traders might look to increase the convexity of their books (buy bonds with the highest duration sensitivity to changes in yield), equity traders could be chasing stocks with the greatest pace of price appreciation for a given decline in capital cost, endlessly bidding up speculative growers in the tech world, at the expense of value and yield. 

These ideas would certainly be consistent with what we witness almost daily in today’s market, which appears to be obsessed not just with innovation, but with all manners of futuristic buzzwords. In today’s world, computing is not enough, you need quantum computing, automation is not enough, you need AI, databases are not enough, you need blockchain, trucks are not enough, we demand cybertrucks.

But of all the tech-obsessed endeavors, my favorite is probably space exploration. When it comes to creating the longest cash flow duration imaginable, I can’t think of anything better than spending the next few decades burning through trillions of dollars building spaceships, all in the hope of one day dominating the intergalactic travel market. So it is perhaps no surprise that just about every billionaire CEO seems in love with the idea: Elon Musk has SpaceX, Richard Branson has Virgin Galactic, Jeff Bezos has Blue Origin. In a day and age when life on earth seemingly requires a constant supply of face masks, antiseptic wipes, and experimental vaccines, perhaps the time has come for us to propel ourselves into outer space in search of less green pastures. After all, life in one of Elon Musk’s planned human colonies on Mars can’t be all that much different from being locked down in a Berlin suburb. (5)

WHEN APPLES AREN’T APPLES

In his book “The Systems Bible” John Gall introduces a concept he calls “operational fallacy”, which describes instances where systems do not do what they say they do. The best way to explain operational fallacy is to think of a simple term like “fresh apples.” Fresh apples can evoke the thought of strolling through your grandmother’s garden on a late summer day, and picking ripe apples right off the tree, perhaps to make a delicious pie later that day. But “fresh apples” could also be an item you grab from the shelf of a suburban supermarket while quickly pushing your cart down the produce aisle one evening after work. In both examples, the term “fresh apples” is technically correct, yet the two products and experiences are nothing alike. What most people really want is grandma’s apple experience, but that’s exactly what the system cannot provide.

2020’s pandemic and the ongoing economic struggles of the last decades have prompted leaders around the world to implement a variety of support measures to stimulate the economy. Those same decision-makers would no doubt congratulate themselves on what they perceive to have been decisive and successful steps that secured the economy, fostered growth, and protected the integrity of markets through difficult times. Yet the results produced by this complex system of incentives hardly match what most would look for in a prosperous economy. The economic equivalent of grandma’s apple would probably involve a combination of plentiful well-paying local jobs, healthy government finances, and growth. Instead, the current economic landscape delivered stagnant growth, gig-economy, and soaring deficits. 

Perhaps these support measures are more likely to produce supermarket apples: the mechanism through which quantitative easing (by far the largest component of all stimulus attempts) benefits the economy is still unclear, and one could argue that QE is in fact counterproductive. Instead of promoting growth, easy money and low rates may instead lead to misallocation of capital, leading to weaker economies and fueling the vicious cycle of stagnation. 

What these measures did achieve was a spectacular rally in stock price, and this may be because QE is more akin to a form of price control than an economic stimulus. Historically, price control has involved various attempts to reduce the price of goods to curb inflationary forces, but we have no need for that type of price control now. In today’s upside-down, hyper-financialized world, we’re instead attempting to generate growth and inflation by controlling the price of risk, the cost of financial capital. Global markets are supposed to be way too large to be controlled by anyone, but trillions of dollars have a way of coercing even the strongest forces of their will. 

Attempts at price control generally have a terrible historical track record, and while I spent a lot of time justifying the market‘s continued rise in my comments, it’s important to note that the same market dynamics can work just as efficiently in the opposite direction to produce sharp sell-offs and volatility.  This may be the greatest challenge our decision-makers will face: how to navigate our way out of the current QE-fueled trap, and back to healthier market dynamics?  

Eventually, market forces always prevail against attempts to control them. Everything has a price, and even if the current trends remain in place for the foreseeable future, sooner or later, the law of unforeseen consequences will cause distortions created in one part of the market to re-emerge somewhere else, the challenge of 2021 and beyond may be to figure out where that might be.

Syl Michelin, CFA®

SOURCES

(1) https://vimeo.com/98550343

(2) https://wholesale.banking.societegenerale.com/en/solutions-services/markets/cross-asset-research/

(3) www.marketintel.stonex.com

(4) https://www.yahoo.com/now/more-ip-os-have-doubled-in-their-debuts-this-year-than-any-year-since-the-tech-bubble-140607697.html

(5) https://www.space.com/37200-read-elon-musk-spacex-mars-colony-plan.html

2021 INVESTMENT & OUTLOOK GUIDE

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