Undeterred by happenings in the Capitol and a possibly less business-friendly agenda, bulls clearly remain in charge. Every major index made news highs yesterday, including the Nasdaq, Dow Jones, S&P 500 and Russell 2000. Cyclical stocks are accelerating and continuing their 4th quarter leadership position. Banks, in particular, are up 10%+ across the board this week as long-term interest rates surge ahead. Energy, Industrial and Commodity stocks are breaking out. They were all laggards last year. Bitcoin touched $41,000 this morning. It was below $5,000 in March. Elon Musk overtook Jeff Bezos to be anointed the richest man in the world as Tesla surpassed $700B in market cap. Excluding regulatory credits, the company still has not turned in an annual profit.
As you might expect, high dividend stocks in the Consumer Staple and Utility sectors are lagging a bit. Investors are pricing in an extremely robust economy over the coming months. No one needs to concern themselves with safety, valuations, dividends or debt levels when it is this easy to make money in tech and cyclical stocks. I don’t have to tell you that this usually does not end well.
However, there is plenty to be happy about today from an economic perspective. Rising home prices and stock markets are filling consumer balance sheets. Our net worth is a leading indicator for GDP. Consumers today are 20% “richer” than a year ago. This leads to more consumer spending, which is still nearly 70% of GDP.
Another round of stimulus checks are already being sent out. A trifecta win for the Democrats in D.C. means a third disbursement of checks is likely in February. Last year’s trillions in monetary stimulus, sub 2.5% mortgage rates, generationally low auto loan rates, an expanding Federal Reserve balance sheet, vaccine rollouts, and tame CPI numbers are all pointing to 2021’s GDP growth rate being the highest in 30 years. Better economic data is coming.
Interest rates are finally entering the fray as well. In a robust economy, yields should be competitive. At a minimum, they should offer total returns over and above the expected rate of inflation. TIPS, or Treasury Inflation-Protected Securities, are pricing in an expected 2% inflation level over the next 10 years. Even with the 10-year Treasury yield finally breaching the 1% level for the first time since March, buyers are still locking in an annual loss of 1% in purchasing power over the next decade. Yields have doubled in just five months, but they are not competitive with stocks. This adds fuel to the market rally. Recall TINA, There Is No Alternative. All of these stimulus checks and money printing efforts need a home. Stocks, commodities, cryptocurrencies, SPAC’s and private equity are happy to take it all in.
When does the party end? That is the biggest concern today. After last year’s 18% total return in the S&P, we have now had only one down year since 2009 and that was only a 4% drop in 2018. As with the late 90’s, it can continue unabated. In fact, bubble’s greatest gains come during the final stages. The S&P advanced 38%, 23%, 33%, 29% and 21% during the final five years of the last century. Those are massive gains. Who knows if we are in 1996 or 1999?
We got some hints this week of what could derail this. FANG stocks dropped immediately after it became apparent that Democrats were taking the Senate. The reasons are two-fold. One is regulatory, the other is valuation. As we’ve discussed here before, low interest rates mean P/E’s can expand. If there is another $2T stimulus bill with more checks going out, or a large infrastructure, green energy and/or college debt forgiveness bill, this will eventually lead to inflation. Not to mention the debt burden on our balance sheet. The seeds for inflation are already present. One only needs to look at copper, gold, oil or lumber prices over the past six months.
More dollars, inflation and debt levels should bring higher interest rates. Breaking 1% on the 10-year is one thing, but getting back to a normal level of 3% would be a crushing blow to 40+ P/E growth stocks. This fear lasted all of one trading session however, with the Nasdaq up 2.6% yesterday. It is not a concern for today until rates get closer to the level of inflation.
For tech stocks, regulatory concerns may be more of an issue. Biden ran on the promise to make everyone pay their fair share in taxes. He singled out Amazon# in particular. Big Tech has crushed the competition over the past decade. Getting the playing field leveled is a hallmark of Senator Warren. Although she will not have a post in Biden’s cabinet, there are plenty of mini-Warrens that are going to get an easier appointment path with the Senate shift. Bigger companies will not be able to make as many acquisitions over the coming years. This will slow growth, albeit on the edges. It is a negative, but not a huge one yet.
There are other concerns for certain sectors, namely those that will face higher taxes, increased regulations and more aggressive controls on companies reliant upon aggressive fees (think credit cards). We don’t envision the new regime, in the midst of a pandemic, will start with overly destructive policies. This would be more of a concern heading into 2022 once the pandemic is over. History shows very few periods when one political party controls all three chambers so you can be sure something will get done. Neither party will miss an opportunity like this to get their projects approved. Probably not as aggressive as the AOC’s of the world would like, but something that satisfies the majority. Each topic will be addressed, the strength of which could determine the next 10% move in stocks.
Lastly, and most important to the advance, is our monetary punch bowl. So long as the Fed and Government are printing money hand over fist, we are more likely to see asset prices rise. Fed minutes from Wednesday showed nothing on the horizon to stem this theme. Again, this is more of a late 2021 or early 2022 issue. The last money printing exercise lasted four years before the infamous Bernanke Taper Tantrum happened in 2013. 10 year rates rose from 1.6% to 3.0% that year. The frightening part is P/E’s back then were 40% lower than they are today. The math does not add up unless earnings are historically great this year. It is entirely possible with all the money sloshing around.
For now, we enjoy the rally until signs of a correction appear. Be prepared for the hangover, but don’t run for the exits just yet. With the recent equity surge, double check your asset allocation framework and trim where necessary.
North Korea Supreme Leader (a title that sounds like it came from Star Wars) Kim Jong-un is 37 today.
James Vogt, 610-260-2214