Economy

Highlights We remain constructive on the economy and financial markets, … : US households have stored up a great deal of dry powder for consumption once the economy fully reopens, last month’s stopgap fiscal measures will help relieve pressure on the most vulnerable households, and the Georgia Senate results ensure that even more fiscal transfers are in store. … but there is a non-negligible risk that investors will get too excited about the positive backdrop: The exceedingly supportive policy backdrop could easily help the S&P 500 push into the low 4,000s, but it’s not clear what investors will have to look forward to for the rest of 2021 if it ascends to that level early in the year. We do not share the bubble-spotters’ alarm, but we are willing to study their arguments: We like to test our convictions by seeking out opposing views and we therefore read Jeremy Grantham’s bubble essay with great interest. We do not share his urgent concern, and our recommended asset allocations are nearly the mirror image of his, but we are taking a deep dive into his view and its implications. Feature As a grad student on the South Side of Chicago, I used to run on the bike path along the lake. On windless days, the three or four miles north from Hyde Park Boulevard felt especially easy, and I would think, “this is what it’s like when there’s no wind.” Then I’d head for home and discover there’d been a breeze behind me all along. A mile or two in, I’d realize it was no breeze and marvel at how I hadn’t noticed it on the way out. The moral of the story, as I told it then, is that if you think it’s not windy in Chicago, just turn around. Now it seems that it has a broader, weightier lesson: it can be easy to miss the wind when it’s behind you. Jeremy Grantham’s carefully reasoned bubble warning, posted online last Tuesday,1 has inspired us to re-examine our outlook and how widely it’s shared. We are not changing our view – we remain vigilantly bullish – but it is worth devoting ample time to consider the risks to it. This week, we highlight the elements of Grantham’s piece that most caught our attention; next week, we will discuss strategies to try to reduce an investor’s vulnerability to them. The Belated Blue Wave Grantham’s essay highlights vulnerabilities that could come to the fore sometime in the near future, but the Democratic sweep of Georgia’s Senate seats has immediate market implications. By virtue of Vice President-elect Harris’s tie-breaking vote, the Democrats will hold a majority in the 50-50 chamber beginning January 20th. The outcome ensures that the Biden administration will have slim majorities in both houses of Congress for its first two years (pending appointments and special elections). Although a five-seat House majority and the slimmest possible Senate majority will not give the incoming administration carte blanche to enact sweeping legislative changes, it will have an easier time pursuing its agenda than it would have had the Republicans held on to just one of the Georgia Senate seats. Item number one on that agenda is likely to be bulked-up fiscal aid for struggling households, states and municipalities. The economic and market significance of the blue wave is that Congress can now become a full partner supporting the monetary policy aim of erring to the side of providing too much accommodation. With the Fed pledging that it won’t take its foot off the gas any time soon, revived fiscal spending will provide the economy with an incremental reflationary boost that should benefit risk assets. Fiscal transfers will be at least partially funded with increased taxes on corporations and high-earning individuals. Profit margins will narrow, but empirical evidence of a relationship between tax rates and economic growth is elusive (Chart 1). Economic growth is largely a function of growth in the size of the working-age population and growth in productivity. Investment leads productivity – workers become more productive when endowed with more and better tools – but history suggests that investment spending is indifferent to corporate tax rates (Chart 2), as is productivity (Chart 3). Chart 1We Don't Like Taxes, Either ... Chart 2... But They Do Not Seem To Impact Investment ... Chart 3... Or Productivity Growth We are disposed to agree with the idea that higher taxes are a drag on growth. Transferring spending power from the private sector to government apparatchiks is not likely to improve efficiency. Business executives are as fallible as any other experts, however, and changes in tax rates have a smaller multiplier effect than the proposed spending measures. Net-net, we expect that the outcome of the Georgia run-offs will lead to slightly higher interest rates, a steeper yield curve, increased consumption and fewer defaults, a welcome mélange for credit performance and the equities that were left behind as investors flocked to COVID winners. A Slippery Slope Chart 4Bull Markets Tend To Go Out With A Bang [G]reat bubbles are where fortunes are made and lost – and where investors truly prove their mettle. For positioning a portfolio to avoid the worst pain of a major bubble breaking is likely the most difficult part. Every career incentive in the industry and every fault of individual human psychology will work toward sucking investors in. [Emphasis added.] As Jeremy Grantham lays it out, the latter stages of a bull market are especially perilous. Given that bull markets run hot before they end (Chart 4), it becomes fiendishly difficult to resist their pull. The recency bias drives an investor to focus on the most recent data points to the exclusion of older ones, pointing to higher expected returns than might be inferred from a more comprehensive sample. The phenomenon encourages equity overexposure at inopportune times if returns are mean-reverting. Professional investors are as susceptible to recency bias and overconfidence (fueled by having had the wind at their back) as non-professionals, and their judgment can be additionally clouded by career pressures. Those who achieve the longest tenures are at least subconsciously attuned to Keynes’ dictum that it is better to fail conventionally than to succeed unconventionally. Staying at the party too long with lots of others may hold far less risk than staking out a solitary position. The bottom line is that asset management incentives encourage groupthink, especially as late-stage bull markets go into overdrive. Dizzying Heights The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble. Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior, I believe this event will be recorded as one of the great bubbles of financial history[.] Bubbles are only identifiable in retrospect, but several aspects that financial historian Charles Kindleberger associated with manias are evident. Money is cheap and readily available and valuations are quite high. One could argue that anticipation of short-term capital gains is drowning consideration of future earnings for at least some equity investors or, as Grantham puts it, “stocks [are] rising … simply because they are rising.” Make no mistake: Equity valuations are demanding and de-rating appears more likely than continued re-rating. The main valuation metrics clearly indicate that equities are richly priced. The S&P 500’s forward earnings multiple is hovering around two standard deviations above the mean, at heights previously reached only in the late ‘90s and early ‘00s (Chart 5). Price-to-sales is at an all-time high, three standard deviations above the mean (Chart 6, top panel), while book (Chart 6, middle panel) and cash flow multiples (Chart 6, bottom panel) are elevated but not yet extreme. Price-to-sales should rise if markets believe pandemic-induced margin pressure is temporary and will reverse once the country is vaccinated, but the one-plus-sigma surge above pre-COVID levels would seem to be a bit much. Chart 5Equity Valuations Are Pushing The Envelope Chart 6Making A Run At '99-'00 Equity option and IPO activity is redolent of euphoria and overtrading. Equity call option volume has surged to record levels (Chart 7, top panel), reportedly on the back of an explosion in small retail activity, and the put-call ratio has fallen to dot-com-bubble levels as demand for exposure has swamped demand for protection (Chart 7, bottom panel). New IPOs have been coming fast and furious (Chart 8, top panel) at a relatively tender average age (Chart 8, bottom panel). Sponsors’ shift away from hoarding early- and middle-stage returns to inviting the public to share them may prove to be telling. There are many reasons to sell equity interests, but expecting them to blast higher isn’t typically one of them. Chart 7The Merry Men Of Sherwood Forest Have Discovered Options Are A Gas, Too Chart 8Take The Money And Run The Legend Who Cried Wolf This isn’t the first time Grantham or one of his colleagues has expressed concern about rising stock prices. It may be unduly harsh to call him a perma-bear, but GMO has consistently underestimated equities and the firm has seen its assets under management (AUM) cut in half over the last five years, to $60 billion, while its flagship asset allocation fund has lost over 60% of AUM. As an RIA firm executive told a Bloomberg reporter, “I can see how clients lose patience with them. They get defensive way before anybody else.2” It’s important to recognize different commentators’ biases/agendas when evaluating their arguments. Grantham calls out the broker-dealers as perpetual market cheerleaders, but he has a stake in convincing GMO clients and prospects that value investing principles are still relevant. BCA’s business model is far more insulated from markets’ direction, but our research services have a bias to fit inherently unruly markets into tidy narratives. Disclosing the risks to our views is an essential part of our process, but the hypotheses we reject will always get less of an airing than the ones we embrace – no investor has time to read weekly 50-page deliberations. Why Now? The canonical BCA question – So What? – is meant to keep researchers focused on the market relevance of their inquiries. But we have long advocated for a second question – Why Now? – to keep our focus on timeliness. Spotting imbalances, which can take a maddeningly long time to reverse, isn’t enough to earn alpha. To translate macro analysis into promising investment ideas, an investor also needs to identify potential catalysts that might unwind the imbalance. Bull markets become exhausted once so much capital is invested in them that there is no one left to keep buying, just as bear markets end when the urgency to sell dissipates. Sentiment can offer clues into remaining buying or selling power, and the day before the Grantham piece appeared, an experienced financial advisor with a stellar portfolio management record emailed that, “This is one of the few times in my career where I feel like the market is simple and the consensus is right. It almost always feels like there is something obviously bad on the horizon but this market feels like there is really good news on the horizon.” I have known him for over 30 years and can attest to his intelligence, diligence and savvy. His clients are in excellent hands and his constructive take may well be spot on. Indeed, we hope so, since it dovetails with ours, but his assurance gave us pause. For now, it doesn't seem to be universal, as it contrasted starkly with this musing from another trusted confidante (a family office CIO) as 2020 was winding down, “What can be said about work other than make certain we don’t mistake this bull market for brilliance.” Valuation is a notoriously lousy timing indicator and sentiment is a squishy concept that is hard to pin down. Both can remain stretched for a long period of time. An investor shouldn't bet against them unless s/he has a good reason for believing they are on the verge of reversing. Perhaps not having to run on the relative performance hamster wheel like most professional investors gives the family office CIO, who also has a great track record, a little broader perspective, but every investor could use a dose of humility. Skepticism is an essential component of successful investing as well, especially as stocks are making new highs. If you think it’s not windy … Investment Implications We respect Jeremy Grantham’s experience and formidable accomplishments and listen closely to any insights he’s willing to share. We acknowledge that there are many signs of froth across financial markets and that the Kindleberger red line of purchasing assets without regard to their intrinsic merit could be crossed in the not-too-distant future. We echo the sentiment that central bankers are not omnipotent and that easy monetary policy is not a magical elixir. We do, however, assert that the combination of extremely easy monetary policy and a new round of fiscal aid offers equities and spread product a supportive backdrop that should be expected to hold throughout the year provided that markets don’t get over their skis by bidding up asset prices too far. The bottom line is that market vulnerabilities are cropping up but we disagree with the view that they are about to bring an end to risk asset outperform-ance. We remain overweight equities and spread product while keeping an eye out for anything untoward. As we have been saying for several weeks, we are bullish, albeit vigilantly so. One of our roles is to worry for our clients, and we are scanning the horizon for signs of trouble even more thoroughly than normal. Until we see those signs, or until risk asset prices rise so much that they sour their risk-reward prospects, we will stick with our call. On the last point, we are in complete agreement with Grantham: The one reality that you can never change is that a higher-priced asset will produce a lower return than a lower-priced asset. You can’t have your cake and eat it. You can enjoy it now, or you can enjoy it steadily in the distant future, but not both – and the price we pay for having this market go higher and higher is a lower 10-year return from the peak.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1https://www.gmo.com/americas/research-library/waiting-for-the-last-dance/ Accessed January 5, 2021. Grantham is the octogenarian co-founder of Grantham, Mayo and van Otterloo (GMO), a value-oriented asset manager for institutional investors. 2 McDonald, Michael. "Grantham’s Bear Market Call Tests Patience of GMO Fund Investors," Bloomberg, November 24, 2020.