National Post (National Edition)
ENJOY THE BUBBLE, BUT BE PREPARED FOR A RECKONING.
But be prepared for a reckoning in July
As my mentor Bob Farrell famously said, “Bubbles go further than you think, but they don't correct by going sideways,” which has been true during the past several months and right into the present.
The lesson learned in this past year is to never short the market on valuation, at least not without a nearterm catalyst. There are real implications for professional investors to be grossly underweight in a prolonged rally. Do not stay wed for too long on academic or intellectual arguments in a bull market underpinned by sentiment, momentum and liquidity.
But one thing is clear to me, which is that risk markets are very expensive when assessed against the fundamentals and can only be justified by ultra-low policy rates, which is exactly what U.S. Federal Reserve chair Jay Powell said when asked about bubbles at his Q&A session during the Dec. 16 Federal Open Market Committee meeting.
At the same time, backto-back disappointments on payroll data and three months of declines in retail sales have been dismissed as old and stale numbers against an expectation of surging growth ahead, principally from the looming massive fiscal stimulus.
The one issue I have been grappling with and view as a risk to these expectations is how much of the stimulus actually ends up in the real economy as the household sector focuses on maintaining high personal savings rates and de-leveraging through debt repayment. And an accommodative Fed, which is not paying attention to bubbles, is creating and stretching the bounds of reasonableness on market valuations, as investors turn a blind eye toward risk pricing because everyone wants the party to continue.
It took a once-in-a-century global pandemic event, which we are not even through, to have the government and the central bank shock the stock market in March to a level that is 15 per cent higher than what would have transpired without the crisis.
With that in mind, if I have taken away anything from what I've seen, it is that there are real implications for professional investors to be grossly underweight in a prolonged risk-on rally. It is clear that the economic data have no ability to move markets anymore, which was loud and clear after Friday's payroll disappointment when the S&P 500 managed to rally 40 basis points and the Russell 2000 by 190 basis points. And, all the while, Treasury yields keep on rising and have surely flown in the face of my forecasts.
Even so, there really is nothing except a Black Swan event that will stop the stock market from rallying further in the next three to four months. The stimulus cheques are coming. The Fed is not going to do anything but buy assets and press the funds rate to the floor. Inflation is already being widely advertised and priced into bonds. And the fact that the markets shrugged off bad data means that incoming economic information will be treated positively if the numbers are good and dismissed as old news if they are bad.
We just have to wait till July to see how all this plays out. The market is betting that the stimulus will lead to huge spending and not saving, that the economy reopens for good in July, and that the next source of optimism will come from the “infrastructure spend.”
On the other side of the trade, even if I'm right, we won't know until July, so back to Bob Farrell: These bubbles in everything that cannot be classified as safe havens will continue to go further than we think, but if they do end up correcting, the catalysts are probably not going to occur before mid-year.
Just to be clear, based on the Fed doing nothing crazy, fiscal stimulus going through and markets continuing to show patience when it comes to the data, I now feel that you can stay positioned on the long side, but past June, if the pandemic isn't in the rear-view mirror, and the economy isn't reopening for good, that is to me the “Grey Swan” that causes a reset of pricing in the financial markets. If you're trading the markets from the long side, this “get out of jail free” card stays with us until June.
The bottom line is that the near-term catalysts for any meaningful drawdown at this stage are hard to see, with the Fed nurturing low rates at the front end, the curve steepening being seen as a boon for banks and justification to stay long the reflation trade, gargantuan fiscal stimulus, the vaccine rollout and the declining infection rate. I am sensing that the bearish arguments may not play out until much later this year or into 2022.
For now, the market is thriving on liquidity, the Fed and the stimulus, and there are pockets of the market with value, such as energy, banks and select REITs, still trading at steep discounts to their net asset values, and utilities, which have been long forgotten except their 3.4-per-cent dividend yield, which is more than double what income-seeking equity investors will generate from the rest of the market.
A lot of very good news is being priced into all asset classes right now, and there has been plenty of opportunity to fade the trade, but equities in particular have been quick to bounce back sharply. Today, “buying the dip” means jumping in after a three-per-cent sell-off. We have managed to redefine what a correction even looks like. But the markets have assumed that monetary and fiscal ease will be with us for years, even after the coronavirus is fully in the rear-view mirror.
I have trouble with a view that things stay static, but we will see the market's version of what transpires to be put to the test post-June.
Risk may be mispriced, but the markets have laid down their bets. Now we have to wait until we get into the third quarter to see if these bets were right or wrong.