The horserace details of the current runup in tech stocks is absolutely stunning. Economist David Rosenberg summarized the action in the sector. On Wednesday, August 26, alone:
We had some crazy bubble moves—Netflix (+11.6%), Adobe (+9.1%), Facebook (+8.2%), Salesforce (+26.0%) and Tesla (+6.4%). It made the advances … the likes of Amazon (+2.9%), Google (+2.4%), Microsoft (+2.2%) and Apple (+1.4%) look decidedly ho-hum by comparison.
Even “Mad Money” host Jim Cramer, not known for measured caution or excessive humility, finds the “hubris” of those driving the prices “truly incredible,” particularly with regard to Salesforce. It is, quite literally, the best of times in the market. The S&P 500 index (SPX) joined the Nasdaq recently at new all-time highs. There is an epic bubble in the equity markets.
The composite numbers obscure the fact that a good half of the companies in the SPX, five months after both unprecedented monetary and fiscal support began, are still 20% below their peaks. Major portions of the economy—energy, construction materials, banks, aerospace, retail, leisure—have at most retraced half of the ground lost in their stock prices. Even this seems a generous valuation as the economic data on the ground, aside from sensational antidotes from the Home Depots of the economy, seem increasingly dire. A brief list of the most alarming trends might be the postponed eviction crisis, its antecedent mortgage crisis, the accompanying humanitarian crisis,[1] bank-loan tightening, and the slowing decline in unemployment—currently higher than the 2009 peak.
Value stocks have historically averaged 45% of the SPX. In 2000 they amounted to just 30%. At present, they are only 20%. This, according to Bank of America data, constitutes a nearly six-standard-deviation move. To wit, assuming a normal (Gaussian) distribution, we’d expect such an occurrence less than once every 1,000 years. Given that financial markets have been around only a couple hundred years, we might call the current level, to understate it, unusual.
An important caveat is that a Gaussian (bell curve) distribution assumes an efficient market. We contend that this ratio is just another point positive for efficient-market skeptics. The current level makes the 2000 episode in tech stock overvaluation seem tame in comparison. Without teasing out the cause and effect, we’ll simply note the correlation of this spread with the ongoing suppression of interest rates by the Fed in the intervening years.
Reading Volatility
If the stock market were really reflective of the economy, we might expect the 10-year Treasury yield to be materially higher than its current proximity to all-time lows. We might presume inflation pressures to be widespread instead of a decline in CPI and PPI.[2] In fact, despite the market rallying, VIX, the fear gauge tracking volatility, has actually risen significantly.
Volatility has retreated from its March highs but remains quite elevated relative to the market moves. VIX is not the only metric to consider in this regard. The volatility on a one-year option on the SPX is currently unchanged since the beginning of June. For all the optimism in the index price, a plethora of white swans on the horizon is clearly being priced into option premiums. It is the index that is ignoring them.
The standard deviation for the SPX (as indicated by at-the-money volatility) expects there’s a 97.5% chance the index is trading above 1,900 by September 2021 (a two-standard-deviation move). There’s an 84% chance it is trading above 2,652 (a one-standard-deviation move). The 2021 Bloomberg consensus estimate for earnings per share is $165.75. If the collective participants of the index achieve that number, the SPX would have a PE of 16 on the one-standard-deviation move to 2,652. But the probability works both ways. One standard deviation up is 4,148, a 25 PE—substantially higher than anything seen since the top of the dot.com bubble.[3]
Were market participants actually confident in that latter possibility, they wouldn’t be pricing puts so much more richly than calls.
It isn’t hard to understand the concern below the surface. We have commented on the economic landscape already. In addition, there are myriad other white swans, not to mention black ones, that may land in the near future.
There is still a trade war going on with China. Iran is biding its time in hopes of Trump losing in November, but the conflict in that region is very much still alive and well. The usual concerns of North Korea and the Indian/Chinese border persist. Hong Kong and Taiwan have become somewhat more prominent wild cards of late. Still, none are likely to disrupt our regularly scheduled political squabbles.
There is still, however, a global pandemic afoot with multitudinous unknown trajectories, including the possibility of delayed treatments and/or vaccines. Just as banks are pulling in their lending, developed economies have unprecedented public and private debt levels. Meanwhile, the drop in average consumer earned income is likely increasing demand for credit, which in the U.S. has virtually vanished almost overnight. That is a fragile arrangement.
Then there is climate change—an extreme unknown but a known problem. Having previously affected less globally significant economies, that trend is now changing. California, the world’s sixth largest economy, is struggling as a result of limited electricity in a context of increasing heat and water scarcity, plus wildfires.
We assign no probabilities to these events escalating further but simply seek to illustrate the substantial risks not currently priced into equity markets.
The Fed, Inflation, and the Future of Low Growth
The irony of Fed action to stabilize the economy in the face of the most recent swan landing—the coronavirus-induced recession—is that its operations could well be destabilizing the economy in fundamental ways.
While demonstrably ineffective at achieving its desired policy goal of 2% annualized inflation since the Great Recession, the central bank had the audacity to announce at Jackson Hole on August 28 that it is turning to a new policy called “average inflation targeting.” Instead of seeking 2% annualized inflation for any given period, it will seek 2% annualized as an average over time. Since that level has not been consistently achieved over the last decade, the bank will seek inflation “moderately above” its average target “for some time.” Fed Chairman Jerome Powell’s confidence seems to indicate some unused financial alchemy that the Fed has recently discovered (or gallantly resisted utilizing) after previously undershooting its target, yet none was proffered.
Powell’s speech attempted to strike a confident tone that would stoke consumer price expectations, but the economic signals are still deflationary, and the central bank has offered no new policy tool to effect a change. In fact, the Fed, perversely, continues to undermine its goals through ongoing quantitative easing (QE).
First, QE soaks up Treasury securities from the market. Since such securities are pristine collateral utilized for business lending, these operations actually restrict liquidity. If banks increased lending on account of the increased reserves they have as a result of QE, we might experience some inflation. But the Fed has learned the hard way over the last decade that while it can increase bank reserves, it cannot force bank lending.
Second, QE pushes interest rates down. In the Jackson Hole speech, Powell acknowledged low rates are a problem.
Inflation that runs below its desired level can lead to an unwelcome fall in long-term inflation expectations, which, in turn, can pull actual inflation even lower, resulting in an adverse cycle of ever-lower inflation and inflation expectations. This dynamic is a problem because expected inflation feeds directly into the general level of interest rates. Well-anchored inflation expectations are critical for giving the Fed the latitude to support employment when necessary without destabilizing inflation. But if inflation expectations fall below our 2% objective, interest rates would decline in tandem. In turn, we would have less scope to cut interest rates to boost employment during an economic downturn, further diminishing our capacity to stabilize the economy through cutting interest rates.
The Fed wants higher inflation and higher interest rates but consistently pursues policies that drive rates down. How it squares that contradiction is not clear.[4] What is starkly obvious, though, is lamentable parallels with Japan. Rosenberg lays out the problem plainly.
Why is it good to tell the public that it can expect many more years, or even decades, of zero interest rates? Why is that really a good thing, unless you are a debtor or leveraged investor? Is it a good thing to force cautious savers into risk assets where capital can erode (or have bear markets been outlawed)? … Low interest rates depict a fundamentally weak economy and a fundamental deflationary mismatch between savings and investment.
At a minimum, the expected decline in consumer income, as businesses continue to adjust to the new environment, means there is a ceiling on demand—and thus the price consumers will be willing to pay for goods. Beyond that, the scene is set for continued low growth. The low required rate of return will promote ongoing malinvestment. This bodes poorly for a return to higher employment, much less addressing the more intractable issues facing productivity.
This is the unfortunate future investors must face. The prospect of such a challenging economic environment should give pause to investors perched atop some the richest equity valuations in history. Granted, poor prospects in the real economy make assets with real yield all the more attractive, but current prices include an unrealistic premium for that yield. The risks to equities are legion, and Powell has given no real comfort to those currently exposed. The bottom line: We’re in bubble trouble.
[1] https://www.nytimes.com/2020/08/21/business/economy/rent-tenants-evictions.html
[2] https://fred.stlouisfed.org/series/CPIAUCSL; https://fred.stlouisfed.org/series/PPIACO
[3] Occasionally at the bottom of a bear market, a fall in company earnings courtesy of recession has spiked the PE to 25. This is a quite different matter than a high PE at the top of a market cycle.
[4] To be fair, the Fed controls only the short end of the Treasury curve and would like to see the long end rise appreciably. To treat the two as wholly unrelated, however, such that the first can remain low indefinitely without consequence for longer-dated issues, seems to fly in the face of history dating back to at least 1975.