Nick's First Quarter Market Commentary
2021 Market Outlook
Inflation & Asset Prices
2020 left us with some of the most volatile markets ever seen. The S&P 500 fell over 30% in about a month. Followed by the government and central bank coming to the rescue. With stimulus on both the fiscal and monetary fronts, this propelled markets to a new all-time high. Consumers received direct payments from the US Treasury in an unprecedented fiscal stimulus that left the average person concerned about inflation.
The government inflation numbers as measured by the consumer price index (CPI) have shown little inflation over the last decade despite a near threefold increase of the M2 money supply since 2008. (The value cash, checking deposits, savings, money market funds, and CDs)
The way the CPI is measured has changed over the years.1 These changes may have misled the public to believe that inflation is lower than they are experiencing. The hedonic quality adjustments of the CPI and exclusion of certain goods could manipulate how inflation numbers are presented to the public.
Hedonic quality adjustment is a fancy way of saying since certain goods are more advanced than they used to be, they can command a higher price without running up the CPI numbers.2 Take cell phones as an example; When the original iPhone was released, it featured a 320x480 resolution with a 2-megapixel camera and cost $500. Now compare that to the recent iPhone 12, which features a 2,532x1,170 resolution and dual 12-megapixel cameras for around $800. The hedonic quality adjustment of the CPI will show that when adjusted for quality these new iPhones do not cost significantly more than the original iPhone model. In fact, the U.S. Bureau of Labor Statistics data shows that telephone hardware costs significantly less than 10 years ago.3
There is one major problem with all of this: They do cost more. You cannot opt for a new iPhone with fewer features for $500. Therefore, we can say that the price of a new iPhone has increased by 60% since 2008. However, the CPI has reflected only a 21.8% increase from January 2008 to January 2020. This is merely one example of the flawed pricing model of the CPI.
When the public started to receive stimulus checks they started to question the CPI inflation narrative. Even though cell phones have gone up in price, other goods have come down in price. This is leading to lower CPI numbers. The massive increase in the M2 money supply has left even the most economically illiterate worried about inflation. If inflation is not showing in consumer prices, then where is it?
The short answer: asset prices. Real estate, bonds, and stocks. Prices of productive assets have exploded since the Fed’s original QE program in 2008. This asset price inflation is the primary fuel for economic inequality since the poor own little to no financial assets.4 Asset and credit bubbles tend to form during periods of low-interest rates.5 So what has the Fed policy response been to the asset price inflation? Create more of it.
The only tools that the federal reserve has at its disposal are to raise and lower interest rates and print money. Lowering interest rates and printing money is the fed playbook to fight a recession. Both tools create inflation. Maslow’s axiom goes something like, “When the only tool you have is a hammer, everything looks like a nail.”
The fed wants to see higher inflation numbers to ensure that they are doing their job well. They are running a fast and loose monetary policy to keep businesses and consumers borrowing cheaply and money flowing through the economy.
Another result of this is ballooning government deficits and deficit spending. When times are good, the government is supposed to shrink the deficit to save for a rainy day. If you believe Trump’s statement of “The greatest economy in the history of our country” then why is government deficit spending at an all-time high?6 Why is income inequality at an all-time high?7 Why are 63% of Americans living paycheck to paycheck?8 Why are more seniors going into debt?9 The list goes on and on. These are not signs of a healthy and vibrant economy but symptoms of a self-serving oligarchy that has been perpetuated by monetary policy and the fiscal policy of a two-party political monopoly.
The growing gap in wealth inequality has nothing to do with any political aisle but everything to do with monetary and fiscal policy. Giving Americans $2,000 is not likely to reverse these
longer-term trends of growing economic inequality. In fact, it may accelerate these trends and make the wealth dichotomy even worse by accelerating asset price inflation.
Most things in macroeconomic policy have a short vs long term trade-off. Policies that will make things better in the short term may result in long term detriment and vice versa. The Keynesian economists and politicians will always opt to do the easy thing now and kick the can down the road in perpetuity. After all, it is easy to be generous with someone else’s money. It is a short-term gain so they can pat themselves on the back and win reelection. When the whole thing blows up longer-term, they will not be in office anymore and it will not be viewed as “their fault.” This system of economic irresponsibility will eventually come home to roost and may lead to a debt crisis and a deep recession.
Recessions are normal and can provide a healthy reset of the economy. They shake out the weak companies to create a more efficient allocation of resources. A healthy economy in a free market should somewhat mimic natural selection. Artificially low-interest rates and PPP loan/grants have propelled unprofitable “zombie companies” to extreme valuations.10 This has begged the question that I am asked almost daily: Are we in a bubble?
My answer to this question is likely different from most financial advisors. Looking at a traditional measure of P/E ratios for the stock market looks like we are in a massively overvalued asset bubble. When you account for a 0% Fed funds rate, declining US dollar, and weakening demand for treasury bonds, the valuations may not be as bubblicious as P/E ratios suggest. However, I do believe investors should be more cautious of what businesses they are investing in going forward.
I do believe US Treasury bonds are in a bubble. At the time of this writing, a 10-year treasury bond yields 1.1%. The S&P 500 has a yield of 1.55% The relationship between these yields is known as the Fed model. When the yield of the 10-year Treasury bond is above the yield of the S&P 500, the stock market is assumed to be overvalued and vice versa.11 To understand these concepts it’s important to remember that yield and price have an inverse relationship.
If we dive deeper into this simple “Fed Model” and you make the assumption that interest rates cannot go any lower than 0%, you start to see that treasury bonds are in a bubble because their values have tremendous downside potential with little yield or upside price appreciation. This credit bubble could extend beyond government debt and move into corporate bonds as we have seen credit spreads continue to narrow after their widening in March.
A credit spread is a difference in the yield of a corporate bond and a government bond of the same maturity and credit quality. Corporate bonds pay more because there is more default risk to a corporation than a government. A narrowing of the credit spread is reflecting at least two things:
- Investors are feeling confident about buying riskier bonds – lowering their yields with increased demand
- The fed is buying a massive number of treasuries to keep their yields from rising
The graph line represents the difference in yield between a corporate bond and a Treasury bond with the same credit rating and 10-year maturity
I believe that the Fed will continue to stimulate markets by buying these treasury bonds. When they buy these bonds it lowers the yield, making the stock market more attractive.
One of the main risks to markets is a reversal of fed policy. If the fed starts to offload their balance sheet (start selling bonds instead of buying) it will make new treasury bonds more attractive with higher yields. This will cause a fall in the price of both risk assets and treasury bonds because investors can buy a new treasury bond with a higher yield and lower risk than stocks.
What might cause the Fed to reverse policy? A significant increase in inflation would force the Fed to raise interest rates. Inflation will be one of the most important economic indicators in 2021. While I do believe that asset price inflation is prevalent and will continue, this is not the type of inflation that would cause the Fed to stop buying bonds or increase interest rates. 2021 will likely be a demand-pull inflation phenomenon. This is caused by too much money chasing too few goods and services. It will be important to carefully listen to the Fed speeches and analyze where interest rates go from here.
The Case for a Bull Market in 2021
Historically low-interest rates, unlimited QE, pent-up demand from quarantine, a possible end to the pandemic with vaccine rollout, more stimulus, positive economic growth numbers, and a democratic sweep are all looking bullish for equity markets. A combination of these events will likely result in demand-pull inflation as demand outstrips supply available in the economy. The stocks that would benefit the most in such a recovery are the cyclical stocks after a broad economic reopening. However, we believe in a balanced approach that will also focus on the strong performers during COVID that will have staying power in a post-COVID economy.
The Business Cycle
Certain leading economic indicators verify we are in the recovery phase of the business cycle. Using these indicators for Real Business Cycle Modeling is imperative to understand where we are going and where we have been. I will discuss the indicators here with the business cycle as a reference for those who are unfamiliar.
There are four phases of the recovery portion of the business cycle:13
- Low-Interest Rates – We are likely here and moving into #2.
- Demand Growth – We are likely entering here now
- Job Creation
- Enter Expansion Phase
The recovery is looking to be on track with many economic signals verifying this thesis:
- Durable Goods Orders - An increase in new orders for equipment to enhance efficiency often provides the first signal of recovery. Recent durable goods order numbers are on an uptrend.
- Market rally breadth has moved downward toward mid and small-cap stocks that tend to be more cyclical. This is the stock market as a leading indicator of a traditional recovery phase.
- Employment rates rise. – Unemployment have come down significantly since March.14
- Market Manufacturing Purchasing Manager Index (PMI) – This number came in higher than expected, indicating that manufacturing is expanding. This is a measure of economic output.15
- Building Permits – Building permits came in much higher than expected. The permits lead to new
construction and economic activity. The actual number was 1.639m vs 1.55m expected.16
- Interest Rate Spread between the fed funds rate and 10-year treasury yield - a wider spread, by anticipating short rate increases, also anticipates an economic upswing. This spread has continued a widening trend since August.
- Consumer Confidence Index (CCI) - Consumer confidence has been on the upswing since May and has leveled off from September to November. We are waiting on December’s numbers to be released. They are likely higher with the stimulus.
- Conference Board LCI (Leading Credit Index) -Reflects the strength of the financial system to endure
stress. A vulnerable financial system can propagate the effects of negative shocks, resulting in a widespread recession. This index has been on a strong upward trend since June.
If you are of the mindset that the stock market is overextended now, it is likely to look even more overvalued after a stimulus plan from a new administration. I expect this plan to be at least 1 trillion not including infrastructure spending. This is not meant to be a political statement but an analysis of how such policies may affect markets. The asset price inflation will likely accelerate in 2021. I do expect market volatility with ups and downs but with an overall recurring theme of higher asset prices.
The Case for a Bear Market in 2021
Valuations seem stretched by many market metrics. The stock market has become the stay at home casino of the pandemic. Retail investors have exhibited classic herding behavior, driving certain stocks to extreme bubble valuations. A pop in the bubble for some of these herded stocks could become systemic leading to a broader market selloff. The Nasdaq and FAANMGs could face declines from a flood of anti-trust regulations that were widely unsuccessful in 2020.
If the economy starts to make a quick recovery, it may lead to inflation. With heavy inflation, the fed may look to raise interest rates. A rise in rates would likely harm the housing market after the immense melt-up because interest rates are the leading indicator of home prices when adjusted for supply. The rate rise would also likely harm bond and stock values with cyclical stocks seeing the largest declines. Depending on the Fed language, a rise in inflation above 2.5% would signal us to make a move towards consumer staples rather than cyclical stocks.
The leading economic indicators are pointing toward recovery. A rise in interest rates will likely be forecast through these indicators. I do not foresee the case for a bear market to be as likely.
Is the US in a Debt Crisis?
Many say that we will never face a sovereign debt crisis because the US Dollar is a world reserve currency. The probability of the US facing a debt crisis is rising as other central banks are dumping US treasury bonds.
I do not believe a sovereign debt crisis will play out in 2021 but may gradually play out over the next decade.
To help reduce the risk of a sovereign debt currency crisis on a portfolio, it is my opinion that investors should consider decreasing their US dollar exposure and increase their holdings of foreign stocks and foreign bonds. I am of the belief that the risks of holding treasury bonds far outweigh their rewards at this point. When the fed eventually stops buying treasuries, yields may spike, and the bond values will fall across the entire yield curve. Short term treasuries will not be safe from a decline in value but safer than longer-term maturities. Investors with a balance of stocks and bonds should reevaluate their suitability for treasury bonds and speak with us about other alternatives.
Nick O’Hara, CPFA®
Investment Advisor Representative
Aspen Financial & Insurance Services
312 Aspen Airport Business Center, Suite F
Aspen, CO 81611
Phone (970) 925-9090, Ext. 106
Fax (970) 925-6622
Securities and investment advisory services offered through SagePoint Financial, Inc. (SPF) member FINRA/SIPC. SPF is separately owned and other entities and/or marketing names, products, or services referenced here are independent of SPF.
The views expressed here are the view of Nick O’Hara and not necessarily the views of SPF.
Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in the periods of decline. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.
International investing involves special risks not present with U.S. Investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.
Treasuries are debt securities issued by the United States government and secured by its full faith and credit.
Income from treasury securities is exempt from local and state taxes.
- Palmer, B. (2020, December 11). Why Is the Consumer Price Index Controversial? Retrieved January 15, 2021, from https://www.investopedia.com/articles/07/consumerpriceindex.asp
- Frequently Asked Questions about Hedonic Quality Adjustment in the CPI. (n.d.). Retrieved January 15, 2021, from https://www.bls.gov/cpi/quality-adjustment/questions-and-answers.htm
- Bureau of Labor Statistics Data. (n.d.). Retrieved January 15, 2021, from https://data.bls.gov/timeseries/CUUR0000SEEE04?output_view=data
- Sargen, N. (2020, September 03). The Fed's New Strategy: Asset Price Inflation Is The Main Risk. Retrieved January 15, 2021, from https://www.forbes.com/sites/nicksargen/2020/09/03/the-feds-new-strategy-asset-price-inflation-is-the-main-risk/?sh=4b2df9fe7306
- Mauldin, J. (2020, January 02). The Fed Is Creating A Monster Bubble. Retrieved January 15, 2021, from https://www.forbes.com/sites/johnmauldin/2020/01/03/the-fed-is-creating-a-monster-bubble/?sh=394101e22670
- Crutsinger, M. (2020, October 16). U.S. budget deficit hits all-time high of $3.1 trillion. Retrieved January 15, 2021, from https://www.pbs.org/newshour/economy/u-s-budget-deficit-hits-all-time-high-of-3-1-trillion
- US income inequality jumps to highest level ever recorded. (n.d.). Retrieved January 15, 2021, from https://markets.businessinsider.com/news/stocks/income-inequality-reached-highest-level-ever-recorded-in-2018-2019-9-1028559996
- Leonhardt, M. (2020, December 11). 63% of Americans have been living paycheck to paycheck since Covid hit. Retrieved January 15, 2021, from https://www.cnbc.com/2020/12/11/majority-of-americans-are-living-paycheck-to-paycheck-since-covid-hit.html
- Lake, R. (2020, April 01). Why debt among older Americans is going up. Retrieved January 15, 2021, from https://www.foxbusiness.com/money/debt-among-older-americans-increasing
- Consumer Price Index Data from 1913 to 2021: US Inflation Calculator. (2021, January 13). Retrieved January 15, 2021, from https://www.usinflationcalculator.com/inflation/consumer-price-index-and-annual-percent-changes-from-1913-to-2008/
- Chen, J. (2020, August 28). How the Fed Model Works. Retrieved January 15, 2021, from https://www.investopedia.com/terms/f/fedmodel.asp
- Business Cycle - The 6 Different Stages of a Business Cycle. (2019, December 06). Retrieved January 15, 2021, from https://corporatefinanceinstitute.com/resources/knowledge/economics/business-cycle/
- Basu, C. (2016, October 26). Four Stages of Business Cycle Recovery. Retrieved January 15, 2021, from https://smallbusiness.chron.com/four-stages-business-cycle-recovery-20837.html
- Bureau of Labor Statistics. (2021, January 8t). Retrieved January 14, 2021, from https://www.bls.gov/news.release/pdf/empsit.pdf
- United States ISM Purchasing Managers Index (PMI)1948-2020 Data. (n.d.). Retrieved January 15, 2021, from https://tradingeconomics.com/united-states/business-confidence
- United States Building Permits1960-2020 Data: 2021-2023 Forecast: Calendar. (n.d.). Retrieved January 15, 2021, from https://tradingeconomics.com/united-states/building-permits