Return of the Bull blog 1

By: Jonathan V. Bever

Inflation and the Big Mac

Negative yields

Common-sense: Makes-sense: Non-sense.

Using common sense, a few charts, discipline, conversations with smart people, and economic data: we wrote a series of blogs called "The Return to Volatility." As the title implies, we were not expecting a peaceful investment environment. Although things turned out well for the investors, the investment backdrop was not without volatility. However, the market is much more enjoyable with volatility being more predictable for now. Our last series called The Return to Volatility, a seven-series blog written over a 2-year period ended with robust optimism and our bull prediction return. However, the new bull is not the end of the old volatility; volatility can be in both directions, as anyone who has ridden a real bull would know; so, volatility is not just down but up, thereby making timing the market rather difficult.

Here is a quote from our last blog:

"We have been tediously arguing for over two years that our economy and stock market were heading for a slowdown, if not a full-blown recession. Our augment: The Federal Reserve was removing liquidity and putting the brakes on the economy. The Fed did this 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."

The stock market returned well over 10% for 2020, which was our original prediction; we did not adjust during the pandemic. Further, the market is up over 10% since we wrote our last Return to Volatility blog 7, which had our initial introduction to "The Return of The Bull" in September 2020. Now we are asked about our outlook for 2021. It makes sense to address the elephant in the room. The following chart illustrates the historic P/E ratio of the S&P Index relative to the 10- year treasury yield.

Please see chart:

The S&P has a historical price to earnings ratio (P/E) of about 16x, and now it is a whopping: 32x, and the 12-month projected P/E is 22x.

It is hard to believe the 10-year Treasury had a yield of over 15-percent in 1983. It is also not easy to imagine a P/E of 7.15 in 1980. Likewise, it is not easy to imagine the big hair and spandex of the 1980s, but it also happened. (Perhaps high treasury rates take the oxygen out of the room, and we cannot breathe any better than the market).

The bears may point to the high P/E ratio and call it a bubble. However, while the market has a high P/E ratio, it does not appear out of sync with the relative P/E compared with the 10-year rate. The 10-year yield is low, which allows for a high P/E ratio.

The obvious questions: how much higher or lower will rates go? Will the Federal Reserve print even more money to target a lower 10-year rate? If so, perhaps the P/E ratio goes to a new high. Will the economy heat up so much that borrowing rates go up on their own? If so, maybe we have seen the peak in P/E ratios.

The Bears will argue this is simply a bubble and will not end well. That is not our opinion. As we mentioned in a previous blog, we are "the return of the bull" camp. The lower the risk-free rate, the higher the P/E can be. Likewise, the converse is true. So, we believe the 10-year rate will go back down. We do not rule out negative rates here in the US.

Additionally, it makes little sense to assume that national deficits can be supported by money printing and negative rates ad infinitum. Eventually, the government will have to get more tax revenue, which we believe will happen as our economic expansion heats up and the velocity of money picks up.

What if we are wrong about the direction of rates? We are optimistic higher interest rates alone will not derail the market. Underlying our view, we expect earnings for the market to steadily grow and possibly better-than-expected, thereby offsetting the risk of a bear market.

Many say all the "good news" is priced into the market. We say, instead, all the "bad news" is priced into the market. For example, the Fed balance sheet over 7 trillion, the Fed fund target rate is near zero, and the Federal deficit is at an all-time high. In short, inflation is priced in. Please see the chart below, which illustrates the Fed balance sheet, the Fed target rate, and the S&P:

We will make a seemingly contradictory statement: more inflation than expected is coming, and interest rates will remain lower than expected. Let us explain, historically as inflation picked up so did interest rates. Of course, nothing is in a straight line, but the trends were in the same direction. We are arguing for divergence for a longer period: inflation will pick up while interest rates will remain low. This is made possible by the Federal Reserve’s commitment to printing money. Let us be fair here. In the Great Financial crisis, the Federal Reserve and Government had to decide which course of action to take. Do they let the banks fail, nationalize the banks, or print money to bail them out? We all know they printed money. We have been arguing the money printing is a Faustian deal and escape from that deal is probably impossible. Further, we would not be surprised by the Fed's balance sheet of over 9 trillion in the near future.

Regarding inflation, there is an adage, "the cure for high prices is high prices." Essentially, when prices get too high, people cannot afford them, and they do not buy. Fewer buyers and a buildup of inventory lead to a price decline. This can be a chaotic cycle, but it looks like the only solution we are left with; the Fed can no longer be proactive in fighting inflation. However, regarding inflation, a more optimal solution is competition or additional production of the items in demand.

Let us look at “Dr. Copper”.

Copper has been coined as Dr. Copper, as copper prices are said to have a Ph.D. in economics. Copper is widely used in manufacturing, construction, etc.; so, copper spot prices are very sensitive to a recession or recovery out of a recession. Currently, copper spot prices are approaching a historic high. Coming out of a global economic downturn, we are surprised. Please see chart:

Let us look at the Big Mac.

Further, we are surprised by the price of the Big Mac. It does not seem to suffer from deflation. Some may prefer the Whopper, but we do not have that index yet.

Manufacturing ISM is near its high. Again, we are surprised by the strength of the economy during a pandemic. This strength adds to our conviction that we will see inflation pressure later this year, assuming the vaccines are successful enough to bring back more normalcy.

As we stated in our last blog, we expected a return of the bull market, goldilocks economy, that social unrest could peak and settle down. So, far we feel vindicated.

The bears argue, because the 10-year Treasury yield is around 1.41% from almost 16% in the 1980s and that the valuations of growth stocks are extreme; this is an indicator that peak returns are behind us. That is not our argument. Investors will always pay more for the leaders, those who grow earnings, revenues, and dividends. If the value or cyclical stocks can finally grow their fundamentals, they will be rewarded, not because growth is a bubble. Valuations are always relative to another investment with the same potential. One must preserve or grow ones purchasing power.

Further, we do not see yields going back toward 16% any time soon. We are faced with a couple of new variables that are still being understood regarding risk asset valuation. What are these variables? One is negative-yielding debts, which exist in several countries around the globe. Second, is further Quantitative Easing, which we have written about in most of our blogs. Negative rates in the U.S. are still a possibility. It makes sense: rates will not be low forever, and it is non-sense to think debt levels can go on indefinitely; yet, for now, it is the new normal. What is the new normal for fixed income? That gets to the heart of the issue regarding forecasting the return on the S&P. A friend of mine asked me two rhetorical questions: 1. Who has all the cash? 2. What if rates go negative? The simple answer to the second question: if rates are negative it will like having a tax on cash. If cash is taxed, then the money will flow into something more productive.

Regarding money in motion, let's look at the M2 money supply and the velocity of money. The violet line is the M2 money supply, and the dark red line is the velocity of money. The Green line is the Bloomberg Commodity index. Please see chart:

It is our opinion, one of the reasons we have not seen severe inflation from money printing is simply because the velocity of money has gone down. After all, the money printing by the Federal Reserve was to and is to fight deflation.

We are bullish on the economy for many reasons. Below is a list of topics with charts to illustrate some of the rationales.

Yield Curve:

In the short term, we are bullish. Here the yield curve is positive as the longer-term rate is higher than the shorter-term rate. When the short-term rate is higher, and the line is flat, it is called an inverted yield curve.

We are grateful for the steep yield curve (longer duration rates are higher than short duration rates). As we mentioned above, we do not expect rates to go higher in the short term but to be range-bound, if not ultimately negative. Nonetheless, we would not go too far out on the yield curve just in case rates do breakout for a reason we cannot think of now. After all, if the risk is not commensurate with the return, then why take the risk?

The question at this part of the cycle is where interest rates are going to go, how fast the economy grows, and how much inflation and higher taxes will affect the bottom line-the earnings per share for the S&P. Let us look at the S&P earnings and the projected growth of those earnings. The actual EPS is 123.24 and the forward 12-month EPS is 174.9. This is an increase of 51.66 per share!

Our thesis has been that a series of rate hikes in 2018 would lead to a series of rate cuts. A flat or inverted yield curve would lead to a normal yield curve. Quantitative Tightening would lead to Quantitative Easing. The bear markets of 2018 and 2020 would lead to a bull market. Admittedly, the time frame for these cycles was much quicker than we anticipated. The speed of economic cycles is likely the new normal, and we will be expecting this not to change too quickly.

So, then, where is the risk? Before, we suggested the Fed as all-in on stimulation and inadvertently removed their ability to fight inflation. Fighting inflation would require the sacrifice of the stock market and economy. However, the Fed historically does not seem to mind the consequences of their policies; after all, they have the magic money to put everything back on track minus a few players-perhaps a small sacrifice for the bigger picture.

Based on where we are, we know the market is not cheap, earnings will drive the market, and multiple expansion of the P/E has probably peaked.

It is easy to say the market will go sideways for a year, thereby having a lower P/E of around 20x. Likewise, one can easily argue a decline of 20-30 percent as it will get the P/E in line with its historical mean in the teens. The more difficult argument is to look around the corner at what has not happened yet and hold on to your conviction. We argue the year-end return for the S&P index will be well above its historic average return of 10%.


SPX INDEX: 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 commonly followed equity indices, and many consider it to be one of the best representations of the U.S. stock market.

ISM Manufacturing Index, which used to be called Purchasing Manager's Index (PMI), measures manufacturing activity based on a monthly survey, conducted by Institute for Supply Management (ISM), of purchasing managers at more than 300 manufacturing firms. Apr 24, 2020 Investopedia

Quantitative easing (QE) is a monetary policy whereby a central bank buys government bonds or other financial assets in order to inject money into the economy to expand economic activity. Wikipedia The Fed Balance Sheet

FEDL01 Index:

Until March 1, 2016, the daily effective federal funds rate was calculated by the New York Fed as a volume-weighted mean of overnight rates on trades arranged by major brokers. As of March 1, 2016, the New York Fed is reporting the daily volume-weighted median value of trades provided by the brokers. All rates are subject to revision by the New York Fed. Bloomberg

FEDL01: is a spliced series of the mean-based calculated values of the effective rate (prior to March 1, 2016) and the median-based calculated values of the effective rate (from March 1, 2016).


The PMI is compiled and released monthly by the Institute for Supply Management (ISM). The PMI is based on a monthly survey sent to senior executives at more than 400 companies in 19 primary industries, which are weighted by their contribution to U.S. GDP. The PMI is based on five major survey areas: new orders, inventory levels, production, supplier deliveries, and employment. The ISM weighs each of these survey areas equally. The surveys include questions about business conditions and any changes, whether it be improving, no changes, or deteriorating. Investopedia

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.

May 11, 2020, Investopedia


Capacity utilization tracks the extent to which the installed productive capacity of a country is being used in the production of goods and services. For some countries, this concept is reported as the percent of capacity being used for production (as opposed to sitting idle). For other countries, this concept is measured through business surveys (tracking business leaders' opinions on their use of productive capacity). Bloomberg

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.


Velocity of money: The average number of times a unit of money (as measured, for instance, by a monetary aggregate) turns over during a specified period of time. The income velocity of circulation is typically calculated as the ratio of a monetary aggregate to nominal GDP. Bloomberg

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. Roll period typically occurs from 6th-10th business day based on the roll schedule. Bloomberg


SECTOR DESCRIPTION: Deliverable stock is the amount of metal available in the warehouse. On warrant stock is the amount of metal which is good for delivery. SOURCE: Shanghai Futures Exchange: Bloomberg.

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