February 22, 2021 – The biggest factor this morning is the ongoing rise in 10-year bond yields. Higher yields mean lower P/Es for stocks. They impact growth stocks more than value names. As the economy recovers in a rising rate environment, watch for better relative performance from value sectors and a sharp headwind to excessive speculative activity.

Last week was highlighted by a continued move higher for long-term bond yields, a modest correction among high flying tech stocks, and ongoing volatility in the speculative fringes of the stock market. The short squeeze targets like GameStop continued to move back down in the direction of fair value, while SPACs continued to raise billions of dollars chasing investor dreams.

We are in the part of the quarterly market cycle that I sometimes call the information vacuum. Earnings season is largely over. The big economic flood of data that comes out the first week of the month has long been discounted. We have a new President who is reasonably predictable in his behavior. His $1.9 trillion relief bill is winding its way through Congress. While the exact size of the final bill isn’t written in ink, the general outline is. It should become law with checks in the mail by mid-March. All this is known. We also know that virus counts are falling, that millions are receiving vaccine doses, and signs of economic normalization continue. It is also the middle of February, a cold and snowy month this time around. That means it is time for a brief lull before the crocuses and daffodils erupt and we start looking ahead with a brighter smile on our faces. Again, all this is baked into the pie.

So, what isn’t baked in? As I often note, stocks are basically a function of earnings expectations and interest rates. After a better than expected Q4 earnings season, expectations for 2021 have been rising. It is now possible, if not likely, that S&P earnings by the fourth quarter of 2021, annualized, will be about $200. While the flood of Fed money has increased the level of speculative activity, the S&P 500 itself, trading at 19.5x the annualized Q4 2021 number, isn’t out of line with a ten-year bond yield that has, until recently, traded at just over 1%.

I just noted that we are in an information vacuum. When that happens small internal market changes, or sudden unforeseen events, can evoke an outsized reaction. Can and will are two different words. But it makes us pay attention. A few years ago, around this time of the year, President Trump, out of the blue, imposed tariffs on imported steel and aluminum. The market fell sharply, over 10% in just six trading sessions. While I don’t expect any surprise likely to upset markets from President Biden, there are two markers to watch.

The first is the aforementioned 10-year Treasury Bond yield. This morning it is up to 1.37%. That may not seem very high and it isn’t. But just a few days ago it was below 1.2%, and a few months ago it was below 1%. Market watchers are focused more on the rate of change than the absolute level itself. The last time the 10-year rate started to accelerate, the chatter was that the Fed might lay out a timeline for the end of its prolific bond purchase program at the January FOMC meeting. Chairman Powell quickly squashed that idea and rates retreated. But rising economic growth rates evoke rising inflation fears. There are many predictions for GDP growth in 2021. A few months ago, most were centered around 5%. Today, consensus is closer to 7-8%, and some are suggesting even higher numbers. If GDP is about $21.5 trillion, a $1.9 trillion spending bill will add a significant percentage to that total, even recognizing that all of the $1.9 trillion won’t be spent in 2021. Congress is talking about a follow-on infrastructure bill that some suggest could be as much as another $2 trillion, although it is highly unlikely Congress would pass anything nearly that large. Nonetheless, the combination of Fed monthly injections of $120 billion, and massive increases in Federal spending, have gotten the inflation hawks circling overhead.

Higher growth is great for earnings. Higher rates are bad for P/E ratios and stock prices. Until now, the surge in growth has dominated the movement in stock prices. We could be entering a phase when the rise in rates moves to become investors’ primary focus. As I have noted repeatedly, this year is going to be a tug-of-war between the tailwinds of growing earnings and the headwinds of rising rates.

A third element is the rapid rise in speculative activity. We are on pace to have 300 or more SPACs being created this year. Each must find an enticing company to buy at a price so cheap that their stocks will pop higher once the merger is announced. To date, many, if not most, of the companies being bought by SPACs are early-to-mid stage private companies. They have exciting products like electric vehicles or cutting edge medical technology. Some will fly us into space or capture a new world of online sports betting. Few make any money today and many don’t even have revenues. Some undoubtedly will emerge as important new businesses. Many will be asterisks in economic history.

And then, there is Bitcoin. Bitcoin is rising because there are more buyers than sellers. It’s that simple. Even the big institutional hedge fund managers buying it can’t explain the valuation. There are some predicting $100,000 imminently and $1 million not far into the future. If it gets to $1 million, the value of Bitcoin will approach the value of US GDP. I will leave it to Bitcoin enthusiasts to explain why that makes any sense. At $1 million, it would be equal to approximately 50% of the value of the S&P 500.

It’s all fun while the train is chugging up the mountain. But we live in a world where the big boys (and lots of little boys too) buy with leverage, either through borrowed money (e.g., margin) or via derivatives, to leverage their bets. Thus, if the train ever cascades downward, investors will have to delever to cut their losses, or risk wiping out. They reduce leverage by selling good assets. That’s why, when the speculative wave ends, all parts of the financial world will feel some pain. When this will happen is beyond my paygrade. But the market has gotten frothy enough that it could happen at any time.

Those vacuum periods, like now, are a setup for such a correction.

In the past, we have seen some mild but sharp corrections that weed out some excesses but don’t quite flush out all the foolishness. If you have long enough memories, in the Fall of 1998 and 1999, markets had 15-20% corrections that quickly reversed before the Internet bubble finally burst for real in the spring of 2000. Markets don’t always have to end that way. In 1987, stocks went straight up in the face of ever rising rates. That couldn’t be sustained. By August, markets rolled over and fell about 20% into mid-October. The finale was one Monday in October when the Dow fell 22% in one day. There was no recession in 1987. There may not have been one in 2000-2002 if 9/11 hadn’t happened. These were simply value readjustments.

As I noted at the start, the broad market isn’t out of line with the bond market today, selling at 19.5x annualized earnings nine months hence. But that assumes rates stay where they are today. If the 10-year rate is 2% or higher by the end of the year, stocks will face some serious headwinds. If speculative fever clashes with sharply rising rates, it is likely that rising rates will reduce the fever at a minimum.

Investors ride waves of momentum…until the momentum runs out. There simply aren’t 300+ attractive private companies for SPACs to buy. Bitcoin isn’t going to be more valuable than the entire stock market. When corporations tell you they are putting working capital cash into Bitcoin, that should remind you of the idiotic idea of taking United Airlines private via a leveraged buyout (a notion that ended that craze). There is a fine line between sane momentum investing and illogical behavior. Smart seniors are asking their Robin Hood following grandkids what they are buying? Really? We don’t have to go all the way back to square one, but this is that vacuum moment to be careful.

Saturday, Warren Buffett will issue his annual letter. For the past 1, 5, and 15 years, Mr. Buffett and Berkshire Hathaway have underperformed the S&P 500. Has he lost his magic at age 90? It certainly hasn’t been a value investor’s time to shine. But selling Mr. Buffett short doesn’t make much sense given his 50-year history. He has always been one of the world’s most logical investors. I strongly suggest that his letter to shareholders, which will be available online Saturday, should be must reading if only to help regain a smidge of the sanity lost in the speculative fringes of this market.

Today, Drew Barrymore is 46. Julius Erving is 71. It is also the 289th anniversary of the birth of George Washington.

James M. Meyer, CFA 610-260-2220