Major averages continued to make new highs pretty much across the board yesterday. Animal spirits keep rising as vaccines are rolled out. An expectation of low rates forever also stokes sideline cash to flow into equities. The Federal Reserve’s meeting on Wednesday added fuel to this already booming fire. More on that in a bit. One can choose multiple acronyms to describe the last few months of positive action.
• FOMO: Fear Of Missing Out on the rally while your neighbor is making money in stocks. When investors chat among their friends, they usually talk about their home runs. It is human nature to want to jump in and join the party.
• TINA: There Is No Alternative to stocks when fixed income options are sub 1%. As we’ve noted on numerous occasions, you are likely better off buying a stable, high-quality company like Coca-Cola# or Bristol Myers# and collect the 3% – 4% dividend yield for the next several years than lock in a bond that is barely giving you 1%.
• FEBB: The FOMC, ECB, BOJ, BOE are the four largest central banks around the globe. Each one is printing money hand over fist to promote growth. FEBB’s are allowing massive risk taking with minimal negative side effects outside of income investors, so far.
• MMTB: More Money Than Brains is a market euphemism used when new investors continue to pile excess cash into hot stocks with no research or care for valuations. The Y2K bubble is a prime example of this as every dotcom IPO was bought without any need to look at a prospectus. DoorDash and AirBnB’s recent listings are more recent examples.
• YOLO: You Only Live Once – As investors take huge gambles with their trading accounts and put 100% of their assets into one stock or commodity. When stocks keep going up, it seems easy.
End result? We have mini-bubbles breaking out. Today they are concentrated in IPO’s, some of the high-flying tech stocks, bitcoin/cryptocurrencies and long-term fixed income. The rest of the stock market’s valuations are above normal but not necessarily a bubble considering the amount of earnings growth coming in 2021 and beyond.
This brings us to the Fed and their proverbial punch bowl. It has been a roller coaster of a ride with respect to fed funds rates over the past few decades. In 2000, the 6th rate increase in two years brought fed funds to 6.5%, the highest level since 1991 and certainly the peak this century. When the Y2K bubble finally popped in 2000, rates were cut for 3 straight years ending at 1% in June of 2003. From here, the housing bubble was formed. Just one year after the last cut, Fed Funds began to increase in order to slow the froth in home prices. This eventually led to a burst in housing and credit markets, helping cause the Great Recession from 2007 – 2009.
We have a chicken and egg debate here. Did the Fed cause a recession by leaving rates too low for too long? Or did the Fed cause the recession by raising rates too fast? Either way, fed funds rate movements are directly tied to bubbles forming and popping.
This week was the Fed’s last meeting of the year and a precursor of what to expect in 2021. They did not disappoint those who are addicted to low rates by any stretch. Let me break down a few key items:
• Most Fed members think it will be appropriate to keep rates at zero until 2023.
• Most Fed members think it will be appropriate to keep rates at zero even if unemployment reaches 3.7% again.
• Most Fed members think it will be appropriate to keep rates at zero even if inflation reaches 2%.
• They will continue to purchase $120B of Treasuries and Mortgage Backed Securities every month. This is further broken down to include $80B in Treasuries and $40B in Mortgage Backed Securities, which is welcome news to the housing sector. Homes can be sold to lower credit buyers if debt is owned by the Fed.
• Chairman Powell noted they are unlikely to taper before the end of 2021. Fed purchases will continue. Auto, business, personal and home loans will be quite cheap for a while.
• Many expected some form of easing on the long end of the yield curve. The Fed can shift their purchases of short paper and buy more 10 – 30 year Treasuries in an attempt to keep long rates even lower. This would also help housing. They did not expand this option, but it remains in their arsenal if needed. If the long end starts running and slows down inflation, the Fed will respond.
• Lastly, and most importantly from my vantage point, was Powell’s response to a question about market valuations. The S&P is trading at 22x forward earnings. Historically, 15x forward earnings is considered fair value. By that metric alone, you could say we’re in a bubble. Powell pointed to a lesser used metric termed Equity Risk Premium. ERP is the excess return that investing in the stock market provides over a risk-free rate. That excess return compensates investors for taking on the higher risk of owning stocks vs. bonds. With interest rates low and “real yields” (your return after inflation) actually negative, the ERP method shows this market is cheap!
That last bullet point is critical for equity investors and those now gambling in the stock market. The way this reads to me is that Chairman Powell will use any tool at his disposal in order to justify keeping rates low. The longer the punch bowl is here, the higher equities and valuations can go. Even if we just kept the 22 P/E, the stock market would have a great 2021 as earnings will rise substantially.
However, we know how this ends. Just like Y2K and the housing market of years past, it will end in disruption. What we don’t know is how long the bull market lasts. It could go on for years if zero rates are here until 2023. Low rate beneficiaries all rose yesterday. Housing stocks were up as it seems like sub 3% mortgage rates could stick around. Most stocks on my screen that have 50+ P/E’s were up as well. Who cares about P/E’s if the Fed doesn’t? Growth wins.
The last piece of the low-rates-for-longer ancillary effect is on the US Dollar. Since we are printing more money than FEBB peers, our currency has weakened. It is now down nearly 14% from the March peak. Currencies usually move like glaciers, so this is a very strong, unusual move for a nine month period. It affects numerous assets classes but mainly commodities which are priced in terms of dollars on a global scale. Gold was up $30 yesterday. Lumber, copper and oil are up 65%, 17% and 34% respectively from the end of October alone. Bitcoin busted out again too, popping nearly $2,000 yesterday alone, and is over $23,000 this morning.
Kindling is there for inflation; will the Fed be able to respond without popping bubbles and wreaking havoc on the markets? Time will tell…and it could be a while before we really have to worry about it. As always, it is prudent to book some gains along the way. Who knows when the next black swan event will happen or the next 10% correction.
Sorry for the length today. With the market closed the next two Fridays, this is my last letter for 2020. Happy Holidays to everyone reading. Stay safe. Here’s hoping 2021 is a great year!
Long list of birthdays: Brad Pitt is 57, Christina Aguilera turns 40. Steven Spielberg is 74. Katie Holmes is 42. Keith Richards is still singing at 77. Ray Liota is 66. Braves fans are happy to have Ronald Acuna Jr. terrorize Phillies pitchers as he turns 23. Lastly, wrestling fans may recognize the names Stone Cold Steve Austin and Rob Van Dam as they turn 56 and 50 today.
James Vogt, 610-260-2214