No one can deny that the market has performed well lately. Since January 2020, global markets have posted impressive returns, even with the 2020 market panic.
However, the party feels like it has started to fade, and everybody seems to be eyeing the exit. The delta variant is slowing the economic recovery. Supply chain issues persist as demand continues to outstrip supply. Inflation concerns abound. China’s recent crackdown on pretty much everything that relates to free-market capitalism. The political divide in our country. Suffice it to say that since April 2020, the easy money has already been made. Now comes the difficult part. Where do we go from here? Will stocks continue to work higher, or are we due for a correction?
Of course, I have no idea what is going to happen. Nobody does. But we can look at the data to put together a pretty decent roadmap of what we think is to come.
What the Data is Saying
GDP is on Fire
Not surprisingly, GDP growth has been great following the Covid shutdowns.
Gross Domestic Product (GDP) is a monetary measure of the final goods and services to be bought by consumers. It is the output of a country.
The Cares Act and recent Covid-19 economic relief packages put a lot of money into businesses and consumer’s pockets. This money has certainly played a major part in the recent economic boom. This, combined with the loosening of Covid restrictions, has spurred the U.S. economic expansion.
Q2 2021 GDP increased at an annual rate of 6.5%. When the infrastructure plans begin to materialize, this will likely help to boost GDP figures.
One common misconception is that the economy boosts the stock market. This is not the right way to look at this. Of course, GDP growth and stock performance are highly correlated. However, GDP is a lagging indicator, along with unemployment rates and inflation figures. Lagging indicators tell you nothing about what is to come. It only confirms what has already occurred.
The stock market is a forward-looking indicator. It is constantly trying to price in probabilities based on the newest available data. This is why you see the market jump up or decline as big events hit the newswire. The stock market is a fairly efficient mechanism for pricing in possible eventualities.
It takes a while for an economy like the U.S. to speed up and slow down (excluding black swan events such as Covid). However, there tends to be momentum behind GDP figures. An economy as complex and big as the United States moves like a freight train. A GDP print as large as 6.5% is a good indication that Q3 will be, at the very least, a positive print.
The Federal Reserve Bank’s goal is to promote “maximum employment, stable prices, and moderate long-term interest rates.” The recent low-interest-rate environment has enabled businesses and individuals to borrow money cheaply and thereby continue growing and expanding. Some of these funds bypass spending altogether and find their way directly to share prices (think those who received a stimulus check only to invest in equities). These actions boost economic activity and subsequently aid stock price expansion.
M2, the supply of money in the U.S., has increased by 32.7% since February 2020. This is unprecedented. We have never seen growth rates this high here in the U.S.
While this may have longer-term concerns (inflation almost always follows this type of behavior, as we are starting to see now), this has been a short-term boon for equity investors. So far, this growth in M2 doesn’t seem to be waning as deficit spending in Washington continues.
There is significant concentration within the S&P 500. Should one or two of the mega-companies suffer a setback, the entire index could suffer.
However, this has typically been the case throughout history. These ten companies represent the best of American innovation, and they are leading as a result. Can they falter? Of course. But another company will likely take its place at some point.
As Jason Zweig pointed out, “Of course, history also suggests that every firm that was expected to dominate indefinitely – from RCA in the 1920s to IBM in the 1980s to Nokia in the 1990s – has ended up slipping. And the idea of virtually limitless growth flies in the face of much of human experience. Trees can’t grow to the sky because they would be bent and crushed under their own weight first.”
The tight labor market is dampening the recent market optimism we’ve experienced so far this year. Demand continues to grow, but most companies are finding it difficult to recruit workers.
Covid uncertainty, unemployment benefits, and child care costs are the biggest cited culprits. If you combine this tight labor market with higher prices, employers are forced to raise their offered wages to hire and retain talent. Higher costs typically lead to lower earnings. However, if this hired talent can result in higher sales or improved efficiency, this can lead to higher earnings.
Leading Indicators Drop Clues
Leading economic indicators help us point to the possibility of a recession. Business cycles look like a roller coaster with periodic peaks and valleys as economic activity waxes and wanes. Declining economic activity can occur before financial market declines.
Many things impact the economy’s direction, but four things drive the underlying economy on a very basic level. These can legitimately be called leading economic indicators. What are they?
- Employment – people lose their jobs
- Income – resulting from loss of jobs
- Sales – people are buying less because they are earning less
- Output – companies reduce output to be comparable to the decreased demand
During an upturn in the economy, these indicators feed into each other, driving prices higher. The sales cycle is extremely difficult to predict, no matter how much economists and those forecasting the stock market try to do so.
By looking at leading indicators, we can see if the business cycle begins to roll over. Traditionally, there are eight things that we can watch:
- Sensitive commodity prices
- Average manufacturing work weeks
- Commercial and industrial building contracts
- Inverted yield curve
- New incorporations
- New orders
- Housing starts
- Money supply
Leading indicators in aggregate are still positive, but their growth rate has declined (which is normal after a big GDP print). It is important to note that while the growth rate is falling, it is still a positive growth rate. Leading indicators are not suggesting that a recession is near. When its growth rate falls
Supply Chain Problems
Most of us were relegated to our homes for almost a year, shopping with Instacart, Amazon, Etsy, and other home delivery portals. We dramatically curtailed spending in certain categories. When you’re wearing yoga pants all day, you don’t need to shop at the retail stores. Our dining out was slashed, as was travel and entertainment. These changes occurred not only in the United States but worldwide.
These lifestyle changes caused wide segments of the world economy to reduce employees and production. Now that the economy is opening up, the demand for many goods and services like restaurants, entertainment, travel, automobiles, and building supplies is in high demand. Unfortunately, these sectors are currently troubled by a lack of employees, materials shortages, and mismatches between expected demand and supply.
Getting back up to equilibrium between supply and demand will take time. Maybe years. In the meantime, limited supply drives prices up as demand remains constant or increases. Of course, an inflationary pressure like this is not a primary driver of longer-term inflation (money supply is). Though it is a real pressure and the effect of supply chain backlogs and higher prices might reduce economic growth and subsequently asset prices, at least for the near term.
China seems always to be a concern for investors. Rightly so. China’s debt levels are exploding. During the past decade, the massive increase in debt and influence has been causing concern around the globe. Due to Covid, China made it easier for citizens to get loans. This led to record debt levels in comparison with the size of its economy.
Adding salt to the Chinese debt wound is that China Evergrande Group is on the brink of default. The company has the most considerable debt burden of any public traded real estate management or development company globally ($300B).
Evergrande rode the Chinese property boom and has urbanized large swaths of the country. The company took on a ton of debt to finance these activities, getting ahead of itself. In recent years, the company has faced lawsuits from homebuyers who are still waiting to complete apartments they partially paid for. There are nearly 800 projects across China that are unfinished. Additionally, suppliers and creditors have claimed hundreds of billions of dollars in outstanding bills.
How China handles its debt remains to be determined, although I suspect that China will step in to assist, though on a limited scale.
Bearish Market Concerns:
Here are a few concerns that I have for the current environment. I do not consider these concerns to be petty or frivolous. Keep in mind, though, that one can find something to worry about in just about any market environment. That being said, here are real concerns that I have.
- Our national debt is absolutely out of control. Any time we take on debt, we pull forward future demand. This leverage is great now. It will put a lot of money into people’s hands. But at some point, we will have to deal with this debt. Will we inflate our way out of this problem? Will we have to settle for higher taxes/lower earnings to pay this off? Or will we attempt to perpetually kick the can down the road?
- Our divided nation. I don’t know how a divided nation can impact asset returns, but I suspect it does not help. There are reports that people will not do business with another due to their political leanings or personal philosophy. This is simply not American. Our diversity is our strength and we need to embrace it. We truly need to unify, not just for portfolio returns, but for the sake of our sanity and our country.
- The Chinese Communist Party (CCP) is becoming a bigger threat by the day. The genocide against Uyghur Muslims, its censorship and propaganda, how it basically took over and fundamentally changed Hong Kong within a year, how it disappears people, etc. China is looking more and more like a totalitarian regime. The word “totalitarianism” was first used in 1926 by Roman Catholic priest Luigi Sturzo to describe then-Italian Prime Minister Benito Mussolini’s fascist government. For Sturzo, totalitarianism represented “the centralization of political and economic life, suppressing all freedom of action and transforming the powers of the state into a single power, both executive and administrative, and thereby reducing it to true dictatorial power.” While authoritarian regimes force the individual to submit to a warped and one-sided sliver of society, totalitarianism is the exaltation of the state above everything else, including both the individual and society.
- Is the market overvalued? According to four of the more popular market valuation metrics, yes.
- Does this mean that there will be a market correction soon? Who knows. These things typically need a catalyst to push the market over the edge. And the party can last quite a bit longer than you think.
Bull Market Thoughts:
- According to the late Richard Russell (the Dow Theory Letters), the Fed’s true mandate is to inflate or die. All other concerns are secondary. I agree with this sentiment. Interest rates are likely to stay as low as possible, despite rising inflation levels. In all likelihood, the Fed will address the inflation problem when it’s too late, as it typically does. Though, for at least the time being, this will be a boon for risk assets and stocks will continue to use this as a strong tailwind.
- Congress continues to spend money, and deficit spending is good for an economy, at least in the near term.
- Covid vaccinations continue, and positive case rates are rolling over. As this trend continues, business activity will surely pick up.
- Stick with a stock bias. Any investment manager worth their salt will tell you that it is always a good idea to have a strong bias towards equities. If you always have a defensive portfolio posture, it will generally not work out well. Your returns will be muted. To help put things into perspective, it helps to zoom out. Over the past 25 years, the S&P 500 has posted a negative annual return only six times.
- Things tend to work out. Yes, there are a lot of things to worry about. There always will be one potential crisis after another. Humans tend to worry about things that never come to pass. As Michel de Montaigne said 500 years ago, “My life has been filled with terrible misfortune, most of which never happened.” Humans are wired to worry. According to psychologist Kate Sweeny, 85% of the things people worry about never happen. It is okay to be prepared and to think things through. Though, it is not okay to worry about things that we have no control over. We have no control over the global economy. We cannot temper inflation. And chances are, despite that fact, things will turn out okay.
If any of you have any questions or if there is anything we can assist with, please feel free to reach out. We are more than happy to help.