National Post (National Edition)
How to survive market mania
Equity market volatility remains acute, with GameStop Corp. serving as the new poster child for the speculative bubble across many swaths of capital markets, following in the footsteps of Tesla Inc. and bitcoin. After traders took silver prices up nearly seven per cent on Feb. 1, I was wondering whether the Hunt Brothers had emerged from the grave.
These are dangerous times, though many investors have adopted “new era” thinking just as they typically do at every market top. What is generally referred to as “liquidity” is really more about “momentum” and “speculation.” This is not about earnings: this past quarter's EPS will end up being nearly 20-per-cent below where the consensus estimate was exactly a year ago in level terms. But the market is up, not just 70 per cent from the lows, but 15 per cent from a year ago, when the market believed profits would be almost 20-per-cent higher than is actually the case.
In other words, the P/E multiple is doing all the work, and investors have an extremely high level of confidence about the future of the economy and corporate profits. I sense that these are going to prove to be false hopes, because I see a bumpy ride after we get to the light at the end of the dark tunnel.
The one thing that rarely gets discussed is how these massive deficits and debts being amassed during the pandemic will get resolved. The total debt-to-GDP ratio across the entire U.S. economy has ballooned to a record 365.5 per cent, from 326.7 per cent before the crisis. In just three quarters, as much debt was added to the nation's books as in the prior two decades combined. In dollar terms, that's US$77.4 trillion, or US$620,000 per household. Contemplate that latter figure since this overhang keeps getting bigger and bigger: it was US$260,000 per household at the height of the 2000 tech bubble, and $475,000 at the peak of the 2007 housing and credit bubble.
Until this massive overhang is redressed, one can reasonably expect the credit multiplier on the real economy to be continuously impaired, money velocity to remain on its secular downward trajectory, precautionary savings rates to stay at elevated levels, deflationary pressures to persist as a result, and interest rates to remain at rock bottom levels.
These low rates can be supportive of asset prices for a while, but their underpinnings will wane as it becomes obvious that we are not heading to the Roaring Twenties and earnings disappoint. It was not interest rates that pricked the 2000 and 2007 bubbles; it was faulty assumptions facing economic reality. We will soon find that central banks are not actually bigger than the market and the business cycle. But at least we have until after the second quarter before these very lofty current economic expectations are put to the test.
The mania has culminated in a view that the retail investor has taken on the institutional investor, but the reality is that the latter is also very one-sided in its overly optimistic view of how things will play out. The retail investor is loading up on the most speculative stocks, whereas the typical portfolio manager, views aside, is trained to manage risk and actually knows, or should know, how to assess the present value of future cash flow streams. If you can't do that, don't call yourself an investor. Call yourself a trader or a speculator.
The day will come when playing the game of pin the tail on the donkey isn't going to work anymore and when companies that don't make money will no longer outperform those with solid business fundamentals and a credible plan to build future residual cash flow streams. Fundamentals can only stay out of vogue for so long, as history teaches us time and again.
I continue to emphasize that sensible investing in today's world is to buy growth companies that have utility characteristics, and you can find these in big tech, consumer staples and health care (notwithstanding potential regulatory risks). On the value proposition, the most prudent risk-adjusted way to play any sort of economic recovery is through financials and energy.
You don't have to be all in cash, but have some on hand so you can help U.S. Federal Reserve chair Jay Powell pick up the pieces when this bubble finally bursts. Don't worry about the timing, just know it's out there and we are a lot closer than we were a month, three months or six months ago. You don't need to be the world's most gifted technical analyst to see that we have been in a broad topping formation for months.
Managing money at all times means preserving capital while capturing part of the upside. J.P. Morgan reportedly once said that he got wealthy not by buying at the lows and selling at the highs, but by being involved in the middle 60 per cent of the bull market. We are well past that point, and using interest rates as your crutch should only go so far, because the only reason they are as low (or negative) as they are now is because of either central bank manipulation, which then means all asset prices derived off the capital asset pricing model are wildly distorted, or the rates market is predicting a future of extremely weak growth in the economy and profits.
Sadly, even as the central bank clowns blow this bubble bigger and bigger, investors can't have it both ways. It's either a case of all assets being distorted — and it is valuable to know that we may all be investing in a Potemkin Village where true intrinsic value is being artificially skewed — or of the current visions of a sustainable and strong recovery being pure fantasy. Perhaps it's a combination of the two. But this is no time to chase momentum or the herd mentality.