Markets have reached the point where after 30 years of relentlessly increasing central bank involvement, monetary policy has become about 99% of what most professional investors consider in making asset allocation decisions. They just don’t tell their clients that and think of Jay Powell and his predecessors as their heroic and infallible defenders of the high valuations that they think will keep them in business no matter how risky the environment becomes. We are still nutty enough to think valuations drive long-term returns just like they have even in the last few decades of Fed insanity.
In 2020 Congress has stepped in to help pay the bills for millions of people that are out of work and the Fed stands ready to buy up the debt created in the process. The real economy is but a sideshow, an afterthought. The current policies are a sort of deus ex machina, an event that comes out of nowhere to miraculously rescue everyone from a horrible situation in works of fiction. That plot device is used in literature or movies and is often considered a bit too good to be true by an observer with an ounce of skepticism. For example, the stranded boys in Lord of the Flies are rescued by a random passing ship. We always found that flimsy and hard to believe.
We would probably all love to be rescued from this trying period that makes the savage life on the island in that novel seem like paradise sometimes. In the world of managing money for other people, believing that the ship will come whenever needed has become a bedrock principle for a lot of investors. We would rather avoid getting stranded on the island in the first place, but the investment industry is dominated by those who seem to put their clients on this island and celebrate when the ship comes. Precious metals and treasury bond markets see a problem with that plot. They don’t see how the story can end well. An equity rally led by fewer and fewer names is another clue that there is a problem.
Stock bears are considered out of touch, yet without ever more extreme Fed policies, stocks would crater. Bulls ignore that part, though the Fed has come in countless times to defend the market because the concerns of the bears had proved prescient. Without this total faith in the Fed backstopping their “investment” activities they could not justify paying the highest valuations in history. While considering Fed posture has always been part of the process, it was never meant to be the only part. We have reached the point where it is, particularly because most managers hug a benchmark and ride with the Fed.
This uniformity of thought often leads to everyone being on one side of the boat. The Nasdaq is now at an incredible three standard deviations above its 200-day moving average with market breadth in the S&P 500 hitting absurdly low levels with only 23% of stocks beating the index.
The Fed has entered the business of allocating risk capital in the credit markets this year as it buys corporate bonds for the first time. It has pushed spreads at least 500 bps tighter in high yield than they otherwise should be given default expectations so that no investor can hope to earn a decent return doing some credit work. Everyone must buy stocks or perish “by order of the Peaky Blinders” crew of monetary policy in the Eccles Building.
We are just not sure to whom current buyers of most stocks expect to sell their long positions given such historically high valuations. At a certain point, even with risk-free rates near zero, it does not make sense to own most stocks unhedged because one is not being compensated for the risk or earning much return. Low rates imply low future earnings growth and that factor offsets the benefit of a low discount rate. Stocks are not worth infinity in a zero-rate world.
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.