May You Live in Interesting Times
This famous quote said to be an English translation of a Chinese curse seems appropriate for the times we are living in. From the pandemic, to the toxic political environment, to the recent storming of the U.S. Capitol building in Washington, D.C., one must believe most are clamoring for less interesting times. I guess that is why it is said to be a Chinese curse. And yet, in the midst of this tumultuous backdrop, the U.S. stock market closed 2020 at or near all-time-highs. How is this possible given both the real human and economic suffering many are still experiencing? The following excerpt from investing legend Jeremy Grantham’s latest missive points out this oddity.
“Today the price-to-earnings ratio of the markets is in the top few percent of the historical range and the economy is in the worst few percent. This is completely without precedent and may be a better measure of speculative intensity than any Special Purpose Acquisition Company (SPAC).”
While no one can know with certainty, we believe the answer lies in the massive fiscal and monetary response to this pandemic. The combined stimulus from the U.S. government and U.S. Federal Reserve (the Fed) over the last 9 months totals over 6 trillion dollars! This was enough to help the economy to begin to recover, stimulate animal spirits, and re-inflate the prices of financial assets. While the financial response to this crisis has seemed to work thus far, will it last? Given it is likely to take many months for most of the U.S. population to be vaccinated, this pandemic is far from over. As such, many small businesses, and the people they employ, may need ongoing assistance for some time.
As we begin 2021 and assess where the financial markets stand, we believe the following are items of some import.
- Financial asset prices are elevated. The “Buffett indicator”, total stock market capitalization to GDP, recently broke through its all-time-high 2000 record. The price-to-sales ratio for the Standard and Poor’s 500 Index (S&P 500) is 2.8 times, or nearly 20% higher than at the top of the tech bubble.
- With the Democrats soon to take control of the executive and legislative branches of government, it is likely more fiscal stimulus will be passed to fight this pandemic. In addition, it seems quite possible that a large infrastructure spending bill could be passed in the next 12 months. Finally, expect tax reform resulting in higher individual and corporate income tax rates. These potential rate increases may be less than once feared by some, given the razor thin majority the Democrats hold in the Senate.
- The Federal Reserve is likely to remain VERY accommodative to financial markets until the economic stresses from this pandemic begin to wane and inflation begins to consistently hit their 2% target. The Fed is currently buying $80 billion dollars per MONTH in U.S. Treasury securities to keep rates low and to stimulate the economy. The growth in the M2 money supply jumped a staggering 25% over the last 12 months.
- The U.S. economy is likely to BEGIN to look more normal as we progress through 2021. As many Americans get vaccinated and the spread of the COVID virus hopefully slows, people will resume some level of travel and entertainment which should benefit these struggling areas of the economy. GDP growth for 2021 should be quite robust assuming the rate of transmission of the virus begins to slow and fiscal and monetary support remain in place.
Strategy
As previously stated, financial asset prices ranging from stocks to bonds appear quite elevated. This does not mean, however, that all stocks are overpriced. As we stated in our last quarterly commentary, there are many “value” stocks that appear fairly priced to even cheaply priced. Value stocks have had their worst-ever relative decade ending December 2019, followed by the worst-ever year in 2020, with spreads between growth and value performance averaging between 20 and 30 percentage points in a single year. While we will continue to own growth companies, we are finding better risk-adjusted return opportunities in value. In addition, given we are likely to see more fiscal and monetary stimulus over the coming year or more, we feel it is important to have some assets in a portfolio that may benefit from rising interest rates. The playbook for the last 40 years has largely been defined by a falling interest rate environment. While we aren’t expecting any near-term sustained jump in inflation, as we look out over the next 5 years, we believe the probability that we enter a different environment, one of rising interest rates, is increasing. That will require a different playbook. One that we are already beginning to think about. For now our mantra remains, proceed but with caution.
As always, we remain committed to helping you achieve your financial goals. We wish you and yours a healthy and prosperous 2021.
