By: Jonathan V. Bever
Casey Stengel "Never make predictions, especially about the future."
We will heed his advice.
In the following pages, we are going to argue that we are transitioning to a new era in the investment world; a paradigm shift is taking place. We see it highly probable that a period of increasing inflation, moderately rising bond yields, an improving economy, modest commodity prices, and a new bull market.
Not so fast; we can hear your objections! What about the next presidential election, possibly more social unrest, the recession, bankruptcies, and last but least, the coronavirus? We understand. The negative news is abundant; however, shake it off and look around the corner. Are we not saying volatility is going away? Not a chance.
We are optimistic, while the problems we face today will not necessarily go away soon enough, the severity will. The solutions being implemented have long term consequences, and they are awesome.
Yet, we do believe the battle with the coronavirus will be a multiyear experience.
Please walk with us as we go down the yellow brick road; together we will navigate the economy, the stock market, and the effects of the pandemic. Aside from the potential for volatility, we are extremely bullish.
With all the pessimism, one would think the American Dream is over. The American dream has not gone away; it was merely on vacation being revitalized (its version of social distancing). Interest rates will be low for the foreseeable future not only for governments and corporations but, we believe, eventually will be so for the rest of us. As the Millennial generation finishes college, the economy will continue its slow road to recovery, the coronavirus will be managed effectively, new jobs created for increasing demand, and new families formed will accelerate the demands. So, new homes, new cars, new TVs, new phones, etc. will be needed. To accommodate this expansion, low-interest rates, low energy costs, low commodity costs, and plentiful liquidity to lend to institutions and the consumer. We are going to posit interest rates for the consumer will be much lower. Any politician that can transfer the low rates of the Fed to corporations will be awesome to the consumer, to GDP, and the economy. America doesn't need to be made great; America is great. We simply need confidence, equality, and economic push, and the citizens will do the rest. The Fed would like to have about 2 percent inflation rather than deflation, and low consumer borrowing rates would easily accomplish this.
The policy of lower rates and lots of money printing began in 2008 and now is the accepted norm. Many critics think the unintended consequences will derail the whole scheme. We have considered their logic and find it lacking in one thing: truth. Mostly, it has taken time for the paradigm shift to be accepted by economic tinkerers and public psychology. In short, "the day of reckoning" will be beaten by the innovation of America!
We have been arguing for over 2 years that our economy and stock market were heading for a slowdown, if not a full-blown recession. Our augment: the fed was removing liquidity and putting the brakes on the economy; this was done by raising the fed target rate and unwinding their balance sheet. Volatility arrived first in 2018 conjoined with the beginning of an earnings recession; this earnings recession is still being worked through. The stock market had a nice rebound in 2019 as the market had a P/E multiple expansion.
Ultimately, the P/E expansion was popped by the coronavirus in 2020. We all know what happened when the virus arrived: chaos, economic shutdown, and a severe historic decline in the stock market; not just in the USA but around the world. It would take a steady hand, sharp focus, and emotional discipline to navigate the treacherous stock market environment. There is no place to hide in a crisis, and it exposes those who are qualified and those who are not; it exposes the good and bad in people. Those who survived by smoke and mirrors will come to the end of their road. Meanwhile, we will continue toward the Emerald City and ultimately home.
Regarding the SARS Corona Virus: a lot more is known today than just 6 months ago. We are confident it can ultimately be "beat" by following the guidelines while a vaccine or cure is developed. It will take several years to work through the coronavirus and potentially other SARS viruses; the workaround is not impossible-thankfully in part because of technology and a lot of hardworking people all over the world.
The new Fed policy of lowering rates, printing unlimited QE is a 180 degree from their policy 2 years ago. Therefore, our thesis has turned 180 as well.
Rather than looking for deflation and a recession, we are looking for inflation and a booming economy. We think this will be a process with the likelihood of some short-term pain. To point out the obvious: the business affected by the coronavirus to emerge in a couple of years-assuming technology come to our rescue once again to beat the coronavirus. If we look at history as a clue, we should expect good things. I asked a friend of mine: if you were to print 10 trillion dollars and give it to any country in the world, which country would you give it too? After some thought, he answered the USA: because the USA is the proverbial melting pot of the world. The innovative risk-takers who are willing to work hard seem to end up here from all countries. Sure, we Americans make mistakes, have colossal failures, but we get up, dust ourselves off, and continue toward the good life as we see it.
In the following paragraphs, we will lay out the case for the new bull market and identify the risks and consequences of money printing that began in 2008.
Please see the M2 money supply below: for many years the money supply long term trend has gone up while the fed fun target rate long term trend has been down.
Please see the Federal Reserve balance sheet: the top red line. It was under 4 trillion the end of 2019, went over 7 trillion in June of 2020, and has come down a little. We expect it will be higher by the end of the year.
The second line is the Fed target rate which is 0.10 percent; practically zero.
Taken together the Fed policy went 180 degrees, from tightening to massive stimulation.
The following chart is essential to our inflation forecast. The red line is money velocity. The yellow line is the CPI. The green line is the Bloomberg commodity index.
We argue if the velocity of money goes up so will the CPI, and we will have a lot of inflation. We believe the reason we haven't seen monetary inflation because of the Fed money printing is the fact that the money velocity has gone lockstep down with it. Interesting to note the commodity index has gone down as well. The Fed money printing has been essential in providing liquidity as well as fight deflation.
The following chart shows the PCE on top and the CPI on the bottom:
The Fed uses the PCE (Personal Consumption Expenditure Core Price Index) rather than the CPI (Consumer Price Index). With the longer-term graph, it is easy to see the downward sloping trend which illustrates deflation rather than inflation. Some are concerned that the Fed is all in regarding the fight against inflation and has little chance of fighting inflation should it come in hotter than desired. Some think the Fed not only put the gas pedal to the floor, taking his foot off the brake but has also dismantled the emergency brake and tossed it out the window.
We are not in the camp who believes we will have hyperinflation; although, we don't rule it out completely.
As stated in the beginning, we believe we are headed into a Goldilocks time for our country. Social issues are at the forefront of our populous. We believe the collective consciousness will gradually bring the changes our country needs regarding social issues. While they will always be with us, we believe the severity will ease. This will bring peace back to our streets, and commerce back to the corner retail shops.
Also, low-interest rates in conjunction with moderate to increasing inflation will coexist in peace.
Political economic policy will be accommodating to economic growth. Technology in all sectors, to name a few: healthcare, energy, mining, etc. will be accommodating to economic growth without explosive costs.
As we look at the valuation of the S&P 500, there is no doubt that it is at an above-average P/E ratio.
If we consider the Black Scholes model for pricing a stock option, the denominator is the risk-free rate or the short-term Treasury rate. The lower the denominator the higher the final number. The Treasury rate may turn negative; if so, we are entering a new paradigm for risk asset valuation. As the stock market is an auction each day, we know what the perceived value of each stock is. Where are we going with this? We would not be surprised to see a long period of higher than average P/E ratios on the S&P. So, expecting a market correction because of the perceived lofty valuation may prove frustrating.
In February we wrote in our blog that the market would have a total return of around 10%. It looked as if the pandemic would make it impossible.
However, the speed of rate cuts and QE brought the bear market to a historically quick end.
Further, finding historical value in the market may be a challenge but should be full of rewards for the patient investor. In the next blog, we will illustrate economic pockets of strength, which we believe is just the beginning of economic robustness.
Finally, as commodities have underperformed for years, we expect they may finally be moving into the spotlight in the years ahead. Ultimately, where to invest? Our answer is simply: there's no place like home.
Definitions & Disclosures:
M1: is the money supply that is composed of physical currency and coin, demand deposits, travelers' checks, other checkable deposits, and negotiable order of withdrawal (NOW) accounts. M1 includes the most liquid portions of the money supply because it contains currency and assets that either is or can be quickly converted to, cash. However, "near money" and "near, near the money," which fall under M2 and M3, cannot be converted to currency as quickly.
M2: is a calculation of the money supply that includes all elements of M1 as well as "near money." M1 includes cash and checking deposits, while near money refers to savings deposits, money market securities, mutual funds, and other time deposits. These assets are less liquid than M1 and not as suitable as exchange mediums, but they can be quickly converted into cash or checking deposits. Investopedia
The federal funds rate is the short-term interest rate targeted by the Federal Reserve's Federal Open Market Committee (FOMC) as part of its monetary policy. In December 2008, the target "fed funds" level was replaced by a target range, and this ticker represents the upper bound of that range.
The Fed Balance Sheet 4.1 report, which provides a consolidated statement of the condition of all the Federal Reserve banks, in terms of their assets and liabilities. ... It lists all assets and liabilities, providing a consolidated statement of the condition of all 12 regional Federal Reserve Banks.
Source: May 11, 2020, Investopedia
In the United States, the federal funds rate is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight on an uncollateralized basis. Reserve balances are amounts held at the Federal Reserve to maintain depository institutions' reserve requirements.
S&P 500, or simply the S&P, is a stock market index that measures the stock performance of 500 large companies listed on stock exchanges in the United States. It is one of the most followed equity indices, and many consider it to be one of the best representations of the U.S. stock market.
The average number of times a unit of money (as measured, for instance, by a monetary aggregate) turns over during a specified period. The income velocity of circulation is typically calculated as the ratio of a monetary aggregate to nominal GDP.
Bloomberg Commodity Index (BCOM) is calculated on an excess return basis and reflects commodity futures price movements. The index rebalances annually weighted 2/3 by trading volume and 1/3 by world production and weight-caps are applied at the commodity, sector, and group level for diversification. The roll period typically occurs from the 6th-10th business day based on the roll schedule.
Consumer prices (CPI) are a measure of prices paid by consumers for a market basket of consumer goods and services. The yearly (or monthly) growth rates represent the inflation rate.
PCE deflators (or personal consumption expenditure deflators) track overall price changes for goods and services purchased by consumers. Deflators are calculated by dividing the appropriate nominal series by the corresponding real series and multiplying by 100.
The preferred measure by the Federal Reserve of core inflation in the United States is the change in the core personal consumption expenditures price index (PCE). This index is based on a dynamic consumption basket. ... Before that, the inflation outlook was presented in terms of the CPI.
The views stated in this letter are not necessarily the opinion of Cetera Advisor Networks LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change with or without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results. Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not consider the effects of inflation and the fees and expenses associated with investing.
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