The arbitrary date that much of the Western world has decided to use to change the calendar does little to alter the trajectory of factors driving markets. Yes, there are potential tax considerations at the end of the year, alongside an inherent optimism that comes with the prospect of a full 12 months to reap gains and post returns. In the end, however, credit, momentum, trends, sentiment and valuation are more or less where they were in December. Nevertheless, the start of a new year is the point at which investors tend to opine about the outlook.
Previously, following the market collapse of the first quarter of 2020, we have talked extensively about the evolving market and economic environment. Not much has changed since the last edition, although the result of the Georgia US Senate run-off has profound implications for the outlook, which we will touch on below. As such we will defer from adding to the cacophony of 2021 outlooks and take the opportunity to reflect on the bigger picture.
Is There A Bubble?
Many well-known investors are of the view that there is currently a major bubble in the US equity market. There are many traits that characterize a bubble. The most commonly cited is valuation – it is widely accepted that all prior ‘bubble’ markets have been extremely overvalued. There are many ways to value a market. The ‘Buffett Indicator’ – total stock-market capitalization to GDP – recently broke through its previous all-time high dating from 2000. Robert Shiller’s cyclically adjusted price-to-earnings (CAPE) ratio indicates US stocks are nearly as overpriced as they were during the 2000 technology bubble. The 12-month trailing price- to-earnings (PE) ratio for the S&P 500 is in the top percentile over the period going back to January 1954.1 Each of these valuation measures suggests that the US market currently warrants bubble status.
Another dependable feature of the late-stage equity-market bubble is rampant speculative behavior, particularly on the part of non-professional investors, as the siren call of rising prices draws in the masses and stocks become the talk of the town. On this account account, there is currently no shortage of speculative behavior to observe. The trading of options by retail investors has exploded. The volume of small purchases (of less than 10 contracts) of call options on US equities has increased eight-fold compared to 2019, a year that was already well above the long-run average. Flows into equity markets in the last quarter of 2020 reached record levels.
In the latter stages of a bubble, the combination of lofty valuations and speculative behavior ensures that investment banks are kept busy helping companies tap the capital markets for finance. 2020 was a record year for corporate-debt issuance. There were 480 initial public offerings (IPOs) in 2020, eclipsing the 406 IPOs of 2000. A remarkable 248 of these IPOs were special purpose acquisition companies (SPACs) – shell companies that are created for the special purpose of merging with some private company to take that company public faster than could have been the case with a normal IPO process.
Taking this all together, those advancing the argument that the US market is currently in a bubble have a credible case. But what about other equity markets?
Not So Clear-Cut?
Several equity markets have gone nowhere, in price terms, since the financial crisis. It is far more difficult to argue that these markets bear the hallmarks of a bubble in the same way that the US market does. Another more measurable feature of a late-stage bull market, seen in the run-ups to various bubbles from the 1720 South Sea bubble to the 2000 technology bubble, has been an acceleration of the final leg. It is difficult to have such an acceleration if there has been no sustained advance at all.
It is appropriate to ask why the US market has led such a charmed life since the financial crisis while many other equity markets have languished. At the time of writing, the FTSE 100 is flirting with its 2007 peak and is still below its 1999 high. This of course does not factor in dividends, but the price return of the UK index stands in stark contrast to that of the S&P 500, which at the close of 2020 was 138% above its 2007 peak.2
Perhaps more interesting is that emerging markets (as measured by the MSCI Emerging Markets index in US- dollar terms) have underperformed so substantially since the financial crisis. Emerging markets largely escaped the worst of the financial crisis given its locus was in the US and Europe. During a mammoth +171% advance off the 2008 low to the 2011 high, many argued that emerging-market equities were set to outperform for years to come thanks to better economic fundamentals – younger populations, lower debt levels, and the scope for rapid productivity gains through technological catch-up. Yet, at the end of 2020, the MSCI Emerging Markets index was still below its 2007 peak.3 Needless to say, the rise of emerging markets did not play out as forecast despite better economic fundamentals. So what factor, if any, explains these differing fortunes?
Credit Maketh The Bull
Despite the continued expansion of central-bank balance sheets since the financial crisis, bank credit growth at the global level has been subdued relative to history (beyond the notable exception of China). Thanks to the damage wrought to private-sector balance sheets by the financial crisis, or rather crystallized by the financial crisis, households and businesses – in particular banks – spent subsequent years going through the process of balance-sheet repair: paying down debt and rebuilding equity. On the demand side, even once balance sheets were repaired, for many the psychological legacy of the financial crisis was a greater aversion to credit. On the supply side, regulations introduced post-financial crisis ensured that banks were unable to lend as freely as they did before the crisis. The result was subdued credit growth which directly translated into subdued nominal income growth. As such, the expansion of nominal purchasing power – be it for goods, services or assets – was subdued.
There were of course regional differences in credit growth and availability. Despite being at the epicenter of the financial crisis, the US fared relatively well with respect to the resuscitation of credit growth. Its authorities did a far better job of recapitalizing the domestic banking system than those in Europe. With the process of recapitalizing the banking system taking much longer in Europe, credit growth remained anemic versus the US.
Credit was also tight in emerging markets, on average, but for different reasons. The nature of the global macro-financial architecture, with the US dollar as the reserve currency upon which the global system of credit is built, means that credit conditions in emerging markets are influenced significantly by outside factors, in particular by the US Federal Reserve (Fed). The process of balance-sheet repair in the West, and tighter regulation of the banking sector combined with a relatively weak global economy, conspired to make aggregate credit conditions tight in emerging markets. This ensured that, although these economies largely escaped the worst of the financial crisis, there has been no bull market in the broad emerging-market equity index. When credit conditions are tight, equity markets lack the fuel for a sustained advance.
In tandem with 10 years of relative underperformance versus the US equity market, emerging-market economies perennially disappointed relative to consensus forecasts made in 2011 that they would lead the world out of economic gloom.
This brings us back to the US. Since the US equity market bottomed on March 23, 2020, it has barely paused in its subsequent ascent. It is fair to say that this rampant bull run does not sit atop a humming economy. Covid-19 has exacted a significant toll on the US population and economy, just as it has on others. Economic activity has begun to recover, but has only partially done so. Furthermore, downside risks appear elevated. Some are forecasting a ‘double dip’, and many expect a slowdown as Covid-19-related restrictions are once again increased around the world. With the course of the virus uncharted, there is certainly a high degree of uncertainty. Yet the US market is much higher today than it was in late 2019 when the economy looked fine and unemployment was at historic lows. For those who seek to explain the machinations of the equity market in terms of what is happening in the real financial economy, the ascent since March 23 causes much consternation.
In a recent note, Jeremy Grantham of GMO noted: “Today, the PE ratio of the market is in the top few per cent of the historical range, and the economy is in the worst few per cent. This is completely without precedent”.4 Grantham highlights the current concern of many investors, particularly those who pay heed to valuation. With the economy in the doldrums and recovery far from straightforward, a recovery in corporate earnings is uncertain and leaves economically sensitive assets looking expensive, the implication being that they offer poor prospective returns at current prices. Perhaps the +71.4% gain for the S&P 500 from the March 23 intra-day low to the December 31 close was the omniscient US equity market ‘looking through’ the economic weakness to a recovery in corporate profits for the year ahead.5 The US economy is, after all, improving, and at the time of writing, despite concerns about the impact of the renewed wave of global lockdowns, its economic recovery continues to show sequential momentum.
No doubt, improving expectations for the future have contributed to the advance of the US equity market since the March lows, but this has not been the primary driver. Instead, the expansion of credit by the Fed and US government has been the primary fuel behind this advance. Public- sector credit expansion in response to the Covid-19 epidemic in the US has eclipsed that of any other jurisdiction. Furthermore, market participants have grown accustomed to the apparent impact central banks have on markets. Investors have been conditioned to pile in when the central banks turn dovish. It is no longer a secret that the Fed has pledged its loyalty to supporting asset prices. The man in the street has learned to play the Fed’s game. When retail investors ramp up their interest in the stock markets, they are often derided in professional quarters for their folly. But what is the alternative – sit back and watch institutionalized asset inflation make the asset-rich wealthier still? For those concerned about the impact of central-bank actions on market participants, this is no longer moral hazard but rather moral catastrophe.
The Rules Have Been Rewritten
While the equity-market decline of February and March was swift and brutal, the subsequent recovery has left many asking whether there can ever be a sustained equity-market downturn. If not, equity-market bubbles have been confined to history. Without bear markets there can be no bubble.
Just as bull markets and economic expansions are a function of credit expansion, bear markets and economic downturns are a function of credit contraction. Through the phase of expansion, individuals and businesses overreach. At some point, inevitably, reality falls short of expectations which have been overblown by the underlying credit inflation: there is nothing quite like rising asset prices and incomes to furnish confidence that both will continue. But as reality falls short of expectations, the process of default begins.
But what if governments and central banks no longer allow defaults on any meaningful scale? Several major central banks are already buying corporate bonds, some even equities. It seems unthinkable that central banks could start funneling funds directly to businesses or other entities, as the Reichsbank did in 1920s Germany, literally sending vans of banknotes to businesses so that they could make good on their liabilities. However, 12 years ago it seemed unthinkable that central banks would be buying corporate bonds and equities. We are not for a moment suggesting that there is no risk of a bubble turning to bust in equities or any other market. But the role central banks are playing in markets by way of purchasing assets changes the rules of the game.
In the aforementioned note, Grantham argues that all bubbles end with near-universal acceptance that the current one will not end…yet. This is related to the stock-market proverb that markets climb a wall of worry. When there is no longer anything to worry about, there is no longer a reason to sit on the sidelines: everyone is all-in. At this point the marginal buyer has run dry and the upward trajectory of the market loses momentum as buyers and sellers reach something akin to a state of equilibrium. As the market loses upward momentum, some investors grow nervous and begin to sell, particularly those funding their positions from leverage and thus reliant on continued price gains to service their cost of capital. Subtly, the balance of the market shifts in favor of selling.
Even with hindsight, it is rarely easy to point to the pin that burst the bubble. The main reason for this ambiguity is that bull markets do not tend to break when presented with a major unexpected negative. Bull markets typically turn down when the conditions are favorable, just subtly less favorable than they were, and the buyers run dry.
In the era of hyperactive central banking, is it possible for the marginal buyer to be absent for a period of time long enough for a bull market to turn to a bear market if, whenever the market begins to decline, central banks step in and expand their purchases of securities? It is increasingly clear that central banks have zero tolerance for the financial and economic pain brought about by declining asset prices.
So perhaps the US equity market is in a bubble. It may very well be about to begin the process by which a bull turns to bear. But perhaps not. Current valuations are not a binding constraint on the ability of asset prices to push higher. With the global economy in the process of recovering, monetary conditions exceedingly loose, and central banks committed to supporting asset prices, a further inflation of any bubble is perfectly possible. The bubble may eventually burst – it probably will – but that does not mean that it cannot go on for quite some time. To be clear, we are not arguing for a permanently higher plateau, just acknowledging the fact that the rules of the game have never been quite like this. Money has never been manipulated in quite the way it is today, and therefore so too the price of everything, directly or indirectly, is manipulated as a result.
In the 2011 film Moneyball, Oakland Athletics’ general manager Billy Beane assembles a successful baseball team on a lean budget. By buying players judged to be undervalued by the market, the return on his budget far exceeded that of his counterparts who sought to outbid each other for the best players. Billy Beane was, by necessity, the coaching equivalent of a value investor. Value investing has fallen distinctly out of favor over the last ten years as growth stocks have persistently outperformed. As we have argued previously, there is a growing probability that the set of conditions that have underpinned the persistent relative outperformance of secular growth stocks over the post-financial crisis period are being replaced by something else. This probability has increased further with the Democratic Party taking control of the US Senate following its victories in the Georgia run-off.
With the Democrats in control of both chambers of Congress, the Biden administration has a much freer hand with which to pursue its agenda. This is likely to see larger US government deficits through the coming cycle, ensuring a wider current- account deficit. In tandem with already easy global liquidity conditions and a recovering global economy, this should serve to ease global credit conditions considerably versus the experience of the post financial-crisis decade. As such, the fortunes of those industries and economies where credit conditions have been constrained are likely to begin to improve at the margin. Recent price action indicates that this transition has already begun to play out. Commodity prices have come alive, and so too have emerging-market equities and currencies. This is not to say it will be plain sailing, but we believe that those assets that have spent over ten years falling out of favor stand to gain the most from the continuing macro-financial shifts.
1 Source: Bloomberg, 01.01.21.
2 Source: Bloomberg, 01.01.21.
4 Source: https://www.gmo.com/europe/research-library/waiting-for-the-last-dance/
5 Source: Bloomberg, 01.01.21.
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