"When life is too easy for us, we must beware or we may not be ready to meet the blows which sooner or later come to everyone, rich or poor.”
- Eleanor Roosevelt, February 23, 1940
Life in the time of pandemic has not been easy for most. Yet of late it has been relatively easy for financial markets. Stocks were strong in the last quarter of 2020, finished the year on a very strong note, and climbed in January as well until a hiccup of volatility last week left most US stock indexes closer to flat for the month. Very low interest rates and months of well above average stock returns combined to bring out indications of speculative excess in several ways, last week’s notable addition being unhinged “retail” buying of the deeply troubled “bricks & mortar” videogame retailer GameStop, plus a few other challenged or even already bankrupt stocks. When speculation runs rampant, our own thoughts automatically turn to what could go wrong, which will be the theme of this update. But first, the virus and the economy:
New cases of COVID-19 declined into the holidays, and then the anticipated post-Christmas upturn began by year-end and continued until nearly mid-January. Yet from its recent high of over 255,000 on 1/11, the 7-day average of new cases declined 40% to under 153,000 per day most recently. This decline is that measure’s fastest drop of the pandemic. Hospitalizations also turned down (with a typical lag). Deaths are expected to follow but have only more recently begun to roll over.
After an unheard-of pace for vaccine development and approval, vaccination rollout has been frustratingly slow. However, to date, over 26 million people in the US have received at least one dose and nearly 6 million of those have had both doses of the vaccine. This now includes virtually all nursing home residents which accounted for nearly 40% of COVID-19 deaths to date. We don’t know if there may be one or more up-waves in cases yet to come or if they may trend downward until infection becomes rare. But with increasingly wider administration of highly effective vaccines coupled now with a larger portion of the population than ever that has been infected (with or without symptoms or confirming tests) who are assumed by the scientists to have significant resistance to the virus, it is no longer a question of whether this pandemic will be brought to an effective end in the US (if the vaccines are also reasonably effective as thought on current and future variants). The only question remains, when? And for purposes of markets, whether that proves to be two months or eight months or whatever is of less import than that the end of pandemic is in sight.
The economy continues to recover, though more slowly of late and unevenly. Still, with unprecedented amounts of monetary and fiscal stimulus, more added only weeks ago and an even larger increment (for better or for worse) now expected to follow, and with election uncertainties behind us and an end of pandemic anticipated in months, the market mood is generally positive.
One might think positive conditions would be good for markets and they typically are, but positive news can lead to extreme collective market emotions that tilt to the greed end of the greed-fear continuum. Signs of a market getting too carried away include many we’ve seen of late: a large number of IPOs (most without earnings), high margin debt, surging prices of speculative assets like Bitcoin, and concentration in the largest, very expensive stocks are some we referenced last time. Others include a surge in interest in SPACs (special purpose acquisition companies), a jump in the number of retail accounts at Robinhood and other brokers coupled with an explosion in retail stock option activity, and the previously referenced mania surrounding several distressed companies such as GameStop. The most important caution is overall market valuations that on some measures rival 1999. Episodes in which a casino mentality grips investors ultimately end painfully.
The normal condition is for markets to “climb a wall of worry”, which is when a normal amount of market concerns are highly visible, and since they are known and already discounted, the market rises, defying many expectations. An extreme, but classic, example of this was the market’s negative mood late last March. Yet when the economic news flow is such that market participants can essentially only see the good news, that’s of significant concern. This is when we must focus on what could go wrong:
The Virus: The most obvious concern is the possibility a new strain could defy vaccines and remedies, prove more virulent and deadly, and usher in a new and a worse phase of pandemic. It’s a real threat.
Inflation: We’ve written of this danger before. While we note the most common measure of the money supply has expanded nearly 27% in the past twelve months, we can’t assess the likelihood that money growth will turn into inflation running hotter than markets prefer, but we are entirely confident a higher inflation scenario, should it occur, would greatly upset markets since it would force the Federal Reserve to reverse its easy money policy.
Taxes: The new administration has voiced a preference for higher corporate, capital gain, personal income, and estate taxes. And with control of both houses of Congress now, it’s likely there may be attempts to raise some or all of these taxes sooner or later. Markets assume current elevated levels of unemployment will cause such moves to be both deferred and restrained. Danger exists for markets should such expectations prove wrong. Leaving aside the political question of whether that would be good or bad policy, we’ll just illustrate the potential market impact of one of these. The top federal tax rate for corporations is 21% and there is talk of that potentially increasing to 28% post-COVID. Such a change would permanently reduce after-tax corporate earnings by 7%, which, other things being equal, should reduce the aggregate value of stocks by a similar amount. At current levels of the market, that would imply an eventual drop of 2,100 points in the Dow Jones Industrial Average.
Big-Tech and other Regulation: Aside from other real or imagined benefits, regulation adds costs, with much the same effect as taxes. Just one of the areas of the economy for which substantial new regulation is increasingly discussed is social media which in recent years has become an increasingly important component of marketing campaigns as social media companies monetize the data they collect. Some of the largest technology companies are right in the middle of this, and to the extent big-tech has been a market leader in recent months, substantial new adverse regulation there could take the wind out of the sales of a pillar of the market’s leadership.
Valuation: Markets are expensive relative to historical norms, however, that’s not new. Expensive markets tell us nothing about when that may become a problem for markets, they only tell us that long-term market returns from here are constrained to be lower than average. But overly high valuation sometimes results in sudden corrections that alleviate some of that excess. Moreover, high valuations can make even bubbly investors more skittish and prone to bolt when they think they perceive the first sign of trouble in the other areas mentioned above.
We don’t drag out these four horsemen of bear markets – pandemic, inflation, taxes, and regulation – along with valuation, the ever-present driver of future market returns, to scare anyone or to encourage defensive shifts in portfolios. We simply know the rational investor is the best investor. In an environment marked by widespread and well known good market news and colored by speculative excess, one of the best things we can each do is remind ourselves that market dangers persist in many different forms and ground ourselves with a prudent measure of normal caution.
(Now, a bit of housekeeping: These updates were originally quarterly and had been for a long time. When pandemic turned into a three-fold crisis that also enveloped the economy and markets, we began comments weekly and have been gratified by the broad and encouraging response to these efforts. Several weeks later as market volatility eased, we scaled these back to monthly. Now as stock markets have exceeded former highs and long-awaited vaccines have arrived, our intent is to publish our next market update in two months, as of 3/31, and after that to revert to a normal quarterly schedule. However, we’ll take advantage of the speed and ease of email delivery for any messages we think warrant an interim update, including any driven by unusual market volatility that may develop.)