The stock market of 2020 is the strangest beast we have seen. The word “manic” does not even begin to describe the very illiquid pursuit of popular themes by participants without any regard to valuations. It is like a video game. We do not expect that to last.
We are in a bubble that includes home prices a well. That is a major factor in our understanding of the current environment. The addition of Tesla to the S&P 500 with a $450 billion equity market cap (7th highest in the U.S.) and all the nutty SPAC activity of recent months were all we needed to see to confirm our view that speculation has overtaken common sense in an historic way.
The advance of the pandemic forces us to proceed very cautiously because governments are getting back into the lockdown game. Still, whether the pandemic ends today or next year, most valuations make no sense. Meanwhile, though default risk is masked by the Fed’s interference in the corporate, mortgage, and municipal bond sectors, the risk of defaults and bankruptcies remains high. At the same time, the “free money” from generous jobless benefits is receding.
The Fed now realizes that fiscal policy must come to the rescue or it will lose credibility. Monetary policy will not do the trick to keep markets aloft. More investors now know that. The dispute between the Fed and the Treasury in recent days over the use of funds for emergency lending programs poses another risk heading into the end of this year when liquidity is poor anyway. Key credit markets may become unsettled. Many bonds are priced much too favorably.
Treasuries are not acting as if a growth resurgence is right around the corner even if one allows for QE. At the same time, numerous sectors like the rails that are trading near 25 times peak earnings are so far above historical valuations that we just don’t know what investors are possibly thinking. Something has to give as equities have broadly reached one of those euphoric points that rivals past episodes in the last few years when major corrections ensued.
The historic blowup of quant funds in recent weeks points to how momentum-oriented the investment world has become. Everyone it seems was selling value stocks and buying growth stocks. When participants with PhD’s in math or computers and little fundamental understanding of investments write code to move positions around based on the same noisy data, they all end up on the same side of the boat owning highly overvalued securities. Data mining leads to the endless pursuit of what has been working lately without factoring in the notion that valuations above a certain level require outcomes that are almost impossible to achieve.
The circus is being led by less sophisticated investors. New retail account holders promoting first-level thinking about stocks on social media outlets have played a big role this year.
We wonder if the trip back to a real functioning economy as opposed to one predicated on trillions of dollars of government spending will be a pleasant and orderly one. The current D.C. gridlock would not be such a big deal if economic stability had not become so dependent on enormous fiscal largesse.
With the possibility of a correction increasing in our minds, we do wonder if the Fed will start buying stocks with the indices down 20% or 30%? We also wonder about that because it has so few options left in its mission to kill capitalism in order to defend its legitimacy. Either way, that would be the last frontier of monetary perversion.
It is possible that a fading pandemic as 2021 progresses will provide the catalyst for a further rotation from current market favorites to those that have been ignored or become loathed. However, if the 2000-01 script plays out as we expect, value will perform better than growth, but the direction of the overall market will likely be downward, maybe quickly or perhaps over many months. The dynamics of another tech bubble and fiscal recklessness should not be confused with Fed control of outcomes, though it is always glad to take credit when the S&P 500 is up. When the current speculative blaze begins to fade, there will likely be plenty of time to position for a regression to mean valuations or lower.
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.