Conundrum
CONUNDRUM
As I started to write this letter, I considered which among the many topics of the day I should discuss. One obvious candidate is the resurgence of Covid. Early this summer we were returning to normal. Most were vaccinated. Covid cases were declining. Lockdowns were lifted. Companies were starting to report earnings surpassing 2019 levels—the most recent year untouched by Covid. Then came the Delta variant and Covid cases began to soar irrespective of vaccination status. This has led to much uncertainty. Should we get a booster shot? Do we need to lockdown again?
Another hot topic is supply chain issues. For example, lack of available semiconductor computer chips has dented auto production. The chip supply chain is truly global. Most chips are designed in the US and produced in Taiwan and Korea using equipment from the Netherlands. One weakened link in the chain derails the entire system.
Inflation is yet another topic for discussion. Yes, it is true that the Consumer Price Index is rising somewhat. But there are plenty of examples of more extreme price increases. Shipping rates from Asia have gone from $2,000 per container to $16,000. European gas prices soared to the equivalent of $150 per barrel of oil. And if inflation becomes more widespread, there is a whole subsequent debate about whether or not it will prove transient.
As I contemplated which of these subjects merited further discussion, another thought jumped out at me: Why haven’t any of these negatives hurt the stock market? At the onset of Covid, if anyone had outlined the woes ahead and been asked to make a market prediction, the forecast surely would have been for weak markets. Yet not only have markets not been weak, they have been exceptionally strong. The market is up more than 30% since the eve of Covid last year.
Why?
My best interpretation of the market’s strange behavior is that it acknowledges Covid, lockdowns, supply chain disruption, and inflation, yet concludes “this too shall pass.” In other words, the market is looking down the road and seeing our current problems resolved and bright prospects ahead. The market believes these issues are merely the headlines du jour with little impact on a better future.
This calls to mind Fed Chair Greenspan’s “conundrum” comment regarding the failure of long bond rates to rise in the early 2000s. In spite of soaring short rates, long rates remained stubbornly flat. Now, despite the hit to our economy from Covid lockdowns, supply chain issues, and inflation, how is it that the stock market continues to rise? It’s a conundrum.
Is the market wrong?
Many felt the market was expensive even before Covid. After the impact of the ’08-’09 Global Financial Crisis (GFC) had been fully reflected in ’10 stock prices, they settled in at a multiple of 15x their earnings. From that point, the earnings multiple continued a steady rise to 25x by January 2020, just as news of Covid started to emerge.
Why did the market multiple rise so much during the decade prior to Covid? The standard answer would be that economic prospects faced a sunny future. However, that is a dubious assertion about the economy post the GFC. The hallmark of the broader economic recovery is that it was the slowest on record with stubbornly high unemployment.
Since the onset of Covid, the price to earnings multiple has continued rising from 25x to 35x. This seems nearly impossible. Again, the standard answer of “economic prospects continued to brighten” seems foolish. Prospects brightened during Covid? Actual GDP fell 10% during 2020 and is just now recovering to its level prior to Covid. GDP growth has returned to the tepid 2-3% growth we’ve experienced over the past decade. This does not seem to foretell a rosy future.
Yet, there have been many studies demonstrating that the market correctly prices stocks. This suggests that stock prices relative to their earnings are generally appropriate. But the pricing of stocks over the last decade does not seem rational. Instead, and especially since Covid, stock prices seem crazy. Given the problems outlined at the outset, how could economic prospects be rosy? I am sure that most of us would be happy with just a return to normal. Even though it seems to be good news, the fact that the “new normal” market is at twice the multiple it was at a decade ago just doesn’t add up.
Is the market a bubble ready to pop?
The bubble argument is straightforward. Stock prices have risen far beyond the earnings underlying them. When this has happened in the past, the market has always corrected to bring prices back to their traditional relationship with earnings. Yet our current market seems to be puncture resistant—instead of “popping” and returning to normal, stock prices continue to rise and rise.
A possible explanation for our soaring market is that its underlying structure has changed. There are a couple of reasons why this might be so. Post the GFC, our government embarked on a strange new path of trying to support a weak economy by increasing the money supply, instead of using the more standard economic booster of increasing government spending. Relying on monetary policy instead of fiscal policy took us into uncharted waters. Money printing was being asked to do the job normally assigned to fiscal disbursement. Instead of stimulating the economy, money printing led to vast amounts of liquidity looking for a home. Stocks and bonds proved a ready receptacle, precipitating soaring stock and bond prices. Stimulus to offset Covid has been via the traditional go-to of government spending. This fiscal boost has been accompanied by plenty of stock-price-stimulating money printing.
Another possible change in market structure may be due to the growth of index funds, ETFs, and algorithmic trading. None of these investing strategies are reliant on any measure of valuation. Instead, they are based on price momentum. Take index funds for example. Any new money flowing into an index fund is immediately invested, regardless of stock prices. This tends to increase prices which, in turn, attracts more money, which sparks further price increases, and so on. Valuation has no place in the “decision” making of index funds, ETFs, and algorithmic trading. At a minimum, all of these instruments generate trend behavior. This may have led us into a strange new world where stock prices are not set on any rational basis.
Which brings us back to our conundrum.
As investors, we can choose to interpret this market behavior as normal. That is, the market is in bubble territory and ready to pop. Given that the potential pop lies in the future, we may even believe in its resilience for a bit longer. As Chuck Prince, CEO of Citicorp, famously said, “I’ll keep dancing as long as the music is playing.”
Or we could interpret the market as functioning by different rules due to the change in market structure. If prices are not set by considering valuation, there seems no reason to expect an imminent collapse.
My take is a bit like the quintessential economist who says “on the one hand” offset by the subsequent “on the other.” The future will have price reversals to take account of stretched valuation. But any reversal might be delayed for a long time due to the impact of all the money sloshing around and the rise of value-insensitive investing. Whether the market corrects sooner or later, I believe that careful strategies are needed to identify market winners.
Sincerely,
Sam Stewart,
Partner
This letter is for informational purposes only and does not constitute investment advice or a recommendation of any particular security, strategy, or investment product. The expressed views and opinions presented are for informational purposes only, are based on current market conditions, and are subject to change without notice. Although information and statistics contained herein have been obtained from sources believed to be reliable and are accurate to the best of our knowledge, Seven Canyons Advisors cannot and does not guarantee the accuracy, validity, timeliness, or completeness of such information and statistics made available to you for any particular purpose. Past performance is not indicative of future results.
© 2021 Seven Canyons. All rights reserved. Seven Canyons Funds are distributed by ALPS Distributors, Inc. (ADI).