Markets powered ahead to new highs yesterday as earning season got underway. As I have noted often, the key to the earnings reports to be released over the next few weeks isn’t about the actual results. Rather it is a process of matching those numbers to expectations. Expectations are already priced into stocks. Changes in expectations, triggered by the results and management commentary that follows, will steer the markets in the days and weeks ahead. Note that while some companies have already seen changes in the pace of economic activity, some which are subject to Covid-19 restrictions are just now coming out of the economic cocoon forced upon them by the virus. Thus, managerial comments about future bookings, pricing, etc. in many cases will be much more important than the earnings themselves.
In talking to clients, a most consistent theme is that the market can’t keep going up, that the best of times has been discounted, and somehow there will be payback soon. As the pandemic winds down, everyone understands that the shackles of Covid-19 will disintegrate, allowing a return to normality. But stocks are generally already higher than they were before the pandemic started. So how can they keep moving higher? The general answer is that low interest rates, explosive government spending, and a post-pandemic surge in earnings are the thrust behind the market’s move. None of these forces appear to be ending soon. Fed Chair Jerome Powell has said any increase in the Fed Funds rate is unlikely this year and perhaps even next year. Congress has already passed over $5 trillion in spending bills with another $2.3 trillion on the table. Even more is scheduled to follow. Finally, and most importantly, earnings are surging. Growth expectations are rising. GDP growth this quarter could approach 10% and will likely stay at a high single- digit-pace throughout the remainder of the year. It will be the best economic year in at least two decades.
Perhaps the more apt question is when will it end? What are the signs to watch for that could signal something more than a short term 10% correction? Many of us remember 2000 and 2008. We have no interest in revisiting those times. Thus, what follows is a list, probably incomplete, that offers some answers to the above questions:
Earnings peak. Since stocks are largely a function of earnings and interest rates, stocks will fall as earnings decline. While one can’t wait until the moment when earnings decline to get out of the market, right now we are in the exact opposite set of circumstances. Earnings and GDP are just starting to accelerate. There could be some disruptions relative to supply chain concerns in coming quarters. But those impacts will be overwhelmed by growing demand. It would seem virtually impossible that Americans are going to be in a mood to spend less as the pandemic winds down. Earnings peaks, without a major change in economic direction, are years away.
Inflation, and therefore interest rates, escalate much faster than expected. This is probably the most commonly expressed fear. Anyone remembering the 1970s lived through a period of runaway inflation. When Paul Volcker finally took the necessary action to crush inflation by raising rates and driving down the growth of money supply, investors paid the price. While rates are rising, as are inflation expectations, the current 10-year inflation expectation, as measured by market derivatives, is about 2.4%, hardly out of line with historic norms. With that said, it has been rising steadily for several months. Should it reach 3% or higher, that could be at least a yellow, if not a red flag. We learned in 1987 what happens when stocks and bonds move in opposite directions. Since bonds, stocks, and other financial assets compete with each other for investment dollars, they should be largely in synch most of the time. It is unusual for markets to move in opposite directions for long. Rising bond prices mean lower interest rates. But when bond prices fall and rates rise, logic would suggest bonds will become more attractively priced. The fly in the ointment this time around is the Fed and other central banks are committed to keeping interest rates artificially low. That has pushed money toward risk assets. At some point the Fed will get out of the way and market forces will begin a rebalancing process. But that won’t happen if the Fed is committed to keeping rates low. Therefore, the key will be when the Fed decides it is time to change its message. We don’t want to wait for the Fed to start raising rates. What we will look for, and some expect it as soon as the second half of this year, is word that bond purchases will slow, leading to an eventual drop in rates. But remember, from late 2015 through 2017 the Fed only raised rates approximately once every twelve months. That pace did not disturb the stock market. Only when it chose to raise rates four times in 2018 did the stock market falter and growth slowed. It wasn’t a crash, simply a flat year.
Confidence turns to euphoria. We have already seen pockets of this. IPOs, SPACs, GameStop, etc. But each euphoric bout quickly ran their courses. Perhaps the best measure of investor confidence is the price of Bitcoin. There will be a place for a cryptocurrency over the next few years. A bigger case can be made for the benefits of blockchain in speeding transaction time and reducing the need for financial intermediaries. Blockchain, combined with government issued or regulated digital currencies makes sense. How Bitcoin fits in is open to debate. Instinctively, Bitcoin today has no intrinsic value. It doesn’t generate any income or profit. Price changes relate to the laws of supply and demand, not to any practical use of Bitcoin. The price today is more a reflection of investor confidence than anything else. Today Coinbase, the most prominent platform that trades Bitcoin, is going to go public. Its price is likely to soar. Bitcoin trading volume has soared over the past year. But remember, one of Bitcoin’s fundamental strengths is that supply is limited. There will never be more than 21 million Bitcoins. Well over 19 million have already been mined. Thus, a spike in volume is totally tied to investor interest. Price movements, therefore, are tied to investor psychology. Bitcoin’s total collective value rivals that of the largest public companies. Do you buy $1,000 of Apple stock or $1,000 of Bitcoin? In a bull market sprinkled with euphoria, Bitcoin can do better. But the old saw that markets take an escalator up and an elevator down, applies to Bitcoin like everything else. Since Bitcoin generates no earnings or dividends, it can serve as a measure of investor psychology. No one can argue its strength today. But when speculative bubbles burst, markets unravel. Keep the price of Bitcoin or Coinbase on your radar screen. The speculative bubble will burst before the entire stock market unravels.
Right now, the strength of earnings growth is greater than a reversal of speculation or fears of rapidly escalating inflation. Modest bubbles to date in the stock market have been self-correcting. Treasury bond yields in recent weeks have moved sideways. We are too far into a bull market to sound an all-clear siren; valuations are too stretched for that. But until speculation gets completely out of hand or bond yields start to accelerate, staying with equities remains the best path.
One last caveat. There are only so many investment dollars. Yes, they do rise as markets advance, and they rise as central banks create more money. But there are still only so many dollars out there. As markets approach euphoria, and more and more people want to buy Bitcoin, digital art with NFT tokens, or a new mansion, money will be sucked out of the S&P 500 stocks into these alternatives. IPO booms end when there isn’t enough money left to keep them going. We saw that recently as the SPAC craze moderated. So far, the speculative fringes haven’t disturbed normal markets. But it remains something to watch.
With that caveat aside, however, for now the tailwinds are much stronger than the headwinds. If I had to watch one number over the next six months, it would be the yield on 10-year Treasuries. For several weeks it has been in a narrow range of 1.60-1.75%. It won’t stay there; most likely it will move higher. If it does so slowly, meaning about 10 basis points per month or less, the bulls remain in control of the stock market. If, however, for whatever reason, it starts to rise faster and bond yields surpass inflation expectations, the road ahead for stocks will get a lot bumpier. Anyone can opine on the likely course of future rates. Right now, the best course is to watch and be ready to react.
Today, Loretta Lynn is 89.
James M. Meyer, CFA 610-260-2220