The Fragile Bull

A strong stock market is often equated with economic vitality.  It has been an article of faith that as the economy does better, so will stocks.  Indeed, Donald Trump often pointed to rising stock prices as proof that his administration’s economic policies were working, and was certainly not the first president to do so.

Conventional economic theory holds that the financial markets’ fortunes are the result of basic fundamental forces that are reflected in the value of companies and hence their stock prices.  Wages paid to workers are spent on goods and services, which businesses small and large provide.  The virtuous circle of higher wages leads to more spending, higher company revenues, and greater earnings and dividends for shareholders.  In other words, financial success was driven by production, productivity, and innovation, and it was economic progress that drove the progress of Wall Street.

Today, after twelve years of interest rate “suppression” brought on by the U.S. Federal Reserve’s policy of “quantitative easing” (QE), this relationship has been turned upside down.  The economy has been “financialized,” which is to say, profit making occurs increasingly through financial channels rather than through trade and commodity production.  The prevalence of mergers and acquisitions, initial public offerings, stock buybacks, gaming the income tax system, and the huge increase in debt over the last decade are all symptoms of how financialization has come to dominate markets.  The effect is that the fortunes of Wall Street now have a huge effect on the fortunes of the economy, not the other way around.

Central bank policies are at the heart of the financialization trend.  Artificially cheap money via suppressed interest rates has led to record high levels of debt at both the corporate and government levels, and with the relentless surge in home prices, mortgage holders are not far behind.  Moreover, the Fed continues to create $120 billion per month in liquidity, essentially doubling the size of its balance sheet over the last year.  This has directly fed the speculative fervor on Wall Street and real estate, and left investors dependent on more QE to fuel further appreciation.

Finally, ongoing stimulus payments have introduced another artificial factor into the equation.  There is no doubt that many workers have suffered greatly during the pandemic through no fault of their own.  Government deficit spending was designed for just this purpose—to make up for lost income in times of economic recession.  Personal income growth from all sources spiked a remarkable 21% in the first quarter, and about 40% of that increase was from unemployment and stimulus payments.  The graphic below from Wolf Street blog (www.wolfstreet.com) underscores the huge increase in government compensation during the pandemic.  While it is hard to tell the percentage of recipients that are still truly needy, the fact that businesses are having trouble filling jobs due to enhanced unemployment benefits speaks to the destabilizing effects of this policy at this stage of the pandemic recession.

The result of increasing debt, dependence on the Fed’s liquidity, and job distorting stimulus payments have increased the fragility of the markets, not reduced it.  The old paradigm of a rising stock market reflecting strength no longer holds, we believe, because there are major artificial forces at work today.  The bull market is a fragile one because of this, and investors should take note of these forces as they look to the future.

The first of these factors to come home to roost will be unemployment benefits.  They are scheduled to expire on September 5th, and unless extended by Congress, will represent an abrupt elimination of one of the artificial planks keeping the economy going.  Extension looks unlikely, as numerous state governors have decided to end the benefits early to relieve the pressure on businesses that can’t find enough workers.  This is particularly acute in the service industries such as restaurants and hospitality, which tend to offer low wages.

If that happens, we may see a large drop in income growth and with it, a drop in the consumer spending the U.S. economy has been enjoying.  This could result in a drop in retail sales, home buying (already slowing due to very high prices), and the household savings rate.  Moreover, since only those who are “actively looking” for work are counted as unemployed, a late August surge in job seekers could push up the unemployment rate significantly.  This would upend Wall Street’s rosy outlook for the persistence of the recovery into the year’s end, and no doubt cast a cloud over stock prices.

But it is prospects for the path of inflation that is fueling the greatest debate on Wall Street today.  Despite widespread signs of classic price inflation, the Fed is sticking to its view that inflation is “transitory.”  Inflation has been a fact of life for modern economies, and high inflation has ebbed and flowed, so it has had transitory periods.  But some bouts of inflation have lasted longer than others.

The Fed’s policy of QE, to prop up asset prices, is colliding head-on with the accumulating evidence of inflation.  In a sense, they have allowed themselves to become cornered into choosing between two undesirable outcomes.  On the one hand, if in order to rein in inflation they reduce their monthly provision of QE liquidity, they risk popping the asset bubble they helped create.  With speculation rampant, investors ultra-bullish, and margin debt at all-time highs, a small correction may snowball into a serious bear market.  This risks creating a negative wealth effect, wherein losses in investment accounts and 401ks makes people feel poorer, with the result they spend less.

On the other hand, if they ignore the inflationary evidence and continue to provide $120 billion per month of liquidity, the Fed risks creating a price spiral that is much longer lasting.  In that event they will eventually be forced to raise interest rates at the worst possible time to control inflation.

Quietly, the Fed has already begun to reduce extremely easy monetary policy.  At the June FOMC meeting, in a technical move, the Fed raised the interest on excess reserves (IOER) from 10 basis points to 15 basis points.  It’s hard to describe the increase as a tightening of monetary policy, but it’s certainly not a further loosening.  Markets have taken notice as short-term interest rates have increased substantially.  In his post-FOMC meeting press conference, Chairman Powell said that the Fed would give markets plenty of advance warning on tapering asset purchases.  The question for investors is whether, and when, they will take a more proactive approach to control inflation.  

We may not have long to wait for the answer.  The Fed’s August symposium in Jackson Hole, Wyoming has traditionally been the stage where policy changes are announced, and expectations are high that a change is in the offing at this year’s confab.  In line with recent history, the timing and size of tapering could be signaled at this year’s Jackson Hole meeting.

Investors should understand two key implications of these artificial forces at work today.  First, central banks, led by the U.S. Fed, have perfected “moral hazard”*: everyone from the money manager betting billions to small-time speculators gambling their stimulus money is absolutely confident they can’t lose because the Fed will always push the market higher.  What happens when participants are confident they can’t possibly lose?  They make ever-riskier and ever-larger bets.  The entire nation seems to be in the grip of a moral hazard mania.

Second, organic (i.e. non-manipulated) market forces have been almost extinguished.  There is now only one consequential force, the Fed.  All markets appear to be dependent on the Fed, who seem to rescue every whining gambler whose reckless risky bet is about to go bad.  Traditional security analysis seems about as quaint as a Model T, and the rise of trading in cryptocurrencies, grossly overvalued tech stocks, and meme stocks such as GameStop shows that decisions are being made on the basis of social proof, not sound financial analysis.

How should investors position themselves in this fragile bull market?  We believe that central banks will err on the side of being slow to raise interest rates, and that inflation will be allowed to become more persistent than desired.  That said, inflation indexed Treasury bonds (TIPS) should be considered for a portfolio in these days of rising inflation (and rising inflation expectations).  TIPS are bonds whose principal value is indexed to the Consumer Price Index (CPI) and so compensate their owners by adjusting for inflation.

A corollary idea is to look for companies that pay growing dividends.  For the income-oriented crowd, this is a way to keep portfolio income growing in an inflationary environment.  These can be found among established blue chip consumer staples companies, health care, utilities, and some large energy stocks.

Last, consider value-oriented stocks, i.e. stocks with bargain financial ratios such as price-to-earnings or price-to-sales.  Value stocks are at the greatest undervaluation, relative to “growth” stocks, in history.  This undervaluation gives value stocks some more resilience, we believe, than the overextended growth stocks that dominate markets today.  The recent gap started in 2009, the same time that QE was initiated.  No sector outperforms forever on Wall Street; thus long-suffering value stocks may offer better appreciation potential for the years ahead.

* Moral hazard: lack of incentive to guard against risk where one is protected from its consequences, e.g. by insurance (or the Fed)

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