Happy Holidays, dear readers! Believe it or not, the vast majority of the newsletters we write are not, in fact, for our own entertainment. A couple of them definitely are - notably the April Tin Foil Hat series and the October Halloween series - but apart from those semiannual gems, most of the time we are trying to educate, inform, amuse, explain, entertain, and/or deobfuscate.
This one, however, will likely turn out to be none of that. If you’ve been paying attention to those trade confirmations that hit your inbox at the stroke of midnight, you’ll have noticed that we’ve been busy headed into year-end. The following is a glimpse into what we’re thinking, and why. Fair warning, it may feel a bit like climbing up an Escher staircase. But like we said, this one’s for us.
Part I - Setting the Stage
This time last year, the market had just wrapped up an almost-three-month, almost-twenty-percent decline. It bottomed on Christmas Eve thanks to the Fed doing an about-face and never looked back. The S&P 500 is up something like 30% for 2019 and at all-time highers. The other domestic indices and the international indices have largely followed suit, but without the all-time highs, giving rise to a spirited debate in some circles as to the longer-term direction of the markets.
In point of fact, the trendline that had been in place since the 2009 lows was broken last year, and, despite the absurd market advance in 2019, actually remains broken. But that argument is based entirely on technical analysis, which is the snake oil salesman of investing...except that it so often works.
The scariest four words in investing are “This Time Is Different”. It always pops up at every market peak as a justification for why stocks will keep going up. The problem is, we’re starting to think this time is different.
We personally have not felt fantastic about the stock market from a valuation perspective for the last 6 or so years. Valuations looked stretched back then, and since then they have doubled. P/E multiples look unfavorable relative to historical ranges, and even more so when you do things like smooth out earnings volatility or adjust for profit margins. The math works out to roughly a 50% decline to get back to historically “fair” valuations, and more like a decline of 65%+ to get back to the kind of valuation levels that have preceded every secular bull market in history. Every. Single. One. (See Valuation Newsletter)
But. This time is different because the Fed’s extraordinary (their word, not ours) monetary policy of the last 10 years that seems to have rendered fundamentals irrelevant. The Fed’s balance sheet grew at an annualized rate of 4.5% pre-financial crisis (2003-2008), and never cracked the $1T mark. Post-crisis, the Fed ballooned its balance sheet to $4.5T in a few short years thanks to QE. And it is precisely this ballooning that makes this time different.
Valuations are typically measured as Stock Price (P) divided by Earnings (E), or P/E. The Fed injected $3.5T with a “t” dollars into the economy and concurrently dropped interest rates to zero, making cash a sort of hot-potato that nobody wanted to hold on to. Hence, market prices go higher and higher. The thing is, we have yet to hear a valid explanation of why QE would have any impact whatsoever on earnings.
QE was a massive Keynesian genuflection designed to backstop demand (see History of Economic Theory), so ideally E stays constant at pre-crisis levels. There’s a fair bit of credible research suggesting that continued QE actually has a negligible or even dampening effect on growth, but let’s assume that it contributed to Earnings growth. Real data: S&P 500 earnings grew about 6.5% annually from 2008-2018.
Now, if P also grew at about 6.5% annually over that time frame, you’d expect the P/E multiple to remain constant. More real data: the total value of the US stock market grew from $13T in 2008 to $30T in 2018, or 9% annually. So if the numerator (P) is growing faster than the denominator (E), we should rationally expect the P/E ratio to increase. The question is - is the excess growth in P over the last decade justified, or is it a blowing bubble that will eventually pop?
Part 2 - It’s All About the Fed
At the time QE was implemented, the expectation was that you’d get rampant inflation. More money chasing the same amount of goods and services equals inflation; that’s econ 101. Except it didn’t happen. Or did it? We’d argue that it did, just not in a way that the Fed measures. CPI hedonic adjustments and substitutions are crap. And it doesn’t take into account things like bananas taped to walls or...the stock market.
Thought experiment: imagine a fairly-valued stock market. Now, imagine that the Fed suddenly creates money out of thin air. A lot of money. 25% of the total value of the stock market money. What happens to stock market prices?
Ah, you say, but the Fed can’t print money! That’s solely the purview of the US Treasury and we’d be in some nightmarish MMT world if the Fed started printing money and monetizing the debt!
Knock, knock, Neo.
Take a look at this chart:
The blue line is the Fed balance sheet. The red line is the monetary base. So no, the Fed doesn’t technically print money. They just buy trillions of dollars of US Treasuries with money they don’t have. Money that goes to various banks and other financial institutions to do with as they please.
The issue here lies in trying to figure out what these formulas look like:
P = f(monetary base) and Monetary base = f(Fed balance sheet)
Simplistically, pre-QE you had a 13x multiplier between Fed balance sheet ($900B) and stock market capitalization ($12T). Keeping that 13x multiplier with a $4T Fed balance sheet would yield a $52T stock market cap...some 73% higher than we are today.
Slightly less simplistically, assuming stock market cap growth for the last decade equal to nominal GDP growth (3.8%), the market would only have a $19T capitalization today, instead of $30T. Does that mean that we’re 57% overvalued? Maybe.
But consider that under pre-crisis conditions, Fed balance sheet growth was 4.5%. That would put us at a Fed balance sheet today of just under $1.5T, or $2.5T short of where we actually are. For that “excess” $2.5T to result in an additional $11T of stock market cap would only require a multiple of 4.4x. Assuming the same 13x multiple present pre-crisis, the additional $2.5T of QE money would equate to an additional $32.5T of stock market cap, for an estimated present-day market cap of, again, $52T, and would suggest that we are more like 40% undervalued rather than 57% overvalued.
Now, we are categorically not making a call that markets are headed up another 40% from here. What are simply laying out is a thesis that the stock market is experiencing a sort of inflation as a result of the massive liquidity injections from the Fed. There is an additional $2.5T in the system, and that excess has found its way into the stock market at multiples that are seemingly quite reasonable relative to history.
So. We would argue that yes, the increase in P over and above the increase in E is justified based on the liquidity provided by the Fed. And while a CAPE of 31 is stupidly high relative to history, we would question the basis of that historical comparison given the intentional injection of inflation into the financial markets. But, and this is a key point, that is based on continued accommodative policies by the Fed.
At current levels, markets are starting to seem reasonably valued to us, with potential for modest gains. Any additional liquidity from the Fed (like a continuation of their repo bazooka or an outright QE4) we would expect to see manifest with even more market upside. On the flip side, if the Fed decides to tighten again or begin to “normalize” their balance sheet like they did in the second half of last year, we would expect another rather sudden, sharp market decline, just like we saw in Q4. Going into 2020, it’s all about the Fed.
Part 3 - Hedges
All major indices crossed back above their 200-day MA in mid-late Jan this year, but we didn’t trust the move. We lessened our hedges relative to where they were in December, but kept overweights to gold, US Treasuries, short-term fixed income, and cash throughout the year. All told, we had a 25-30% allocation to what we would consider “hedge positions” this year, relative to the 5% baseline given full allocations across the board for equities.
Despite a 30% gain in stocks, the hedge positions were also up on the year (which could be construed as a further point in support of the money supply vs fundamentals argument we were making above...). But an outlook that has become more accepting of upside potential for stocks by definition will see less opportunity for hedges.
And it is not just opportunity but also outlook for these hedges that has decreased recently. We wrote about the Repocalypse that happened back in September (See Things That Go Bump in the Overnight); fun fact, it turned out to just be JP Morgan trying to get another QE going (mission accomplished!).
But in looking more deeply into the repo market, it seems that there is a very short linkage between repo markets seizing up and forced sales of Treasuries. Couple that with record budget deficits (never mind that we’re 10 years into the longest economic expansion in history), impending outright MMT, and no recession in sight, and Treasuries don’t seem like they have a great risk/reward profile at the moment. We do still expect negative rates in the US, but likely only in response to a recession, which we do not expect this year.
We also can’t stand corporate debt. Ratings are slipping, debt levels are historically high, and while the idea of high yield as a low vol equity play has its appeal, the idea of holding any HY debt out past 2-3 years makes us more than a little queasy.
We still like gold, though that has been pared back a bit in response to a generally more constructive position towards risk.
Stock returns come from three places: earnings, dividends, and multiples. Earnings can be positive or negative, multiples can expand or contract, but dividends are the only constantly positive source of return year after year. As such, we are increasing our allocation to dividend-paying equities, both domestic and international, as well as our REIT allocation.
There will be two additions to portfolios in 2020 as well: an emerging markets debt fund (to broaden EM exposure beyond China and increase risk in a slightly more conservative fashion) and a hedged US equity ETF (one of the Innovator ETFs, for those curious).
If you made it through to the end of this one, go reward yourself with a nice cup of cheer. And if there’s anything in particular you’d like to see elucidated in a future newsletter, let us know! Just because this one was for us doesn’t mean we don’t want to hear from you.
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