Q3 2021 Commentary
Since the markets bottomed in March of 2020, the rebound in equities has been relentless.
Even when markets saw a two-month pullback last fall, the losses were quickly wiped out, and stock prices did not look back.
The moves have not been surprising. The pandemic was met with $10 trillion in combined domestic monetary and fiscal stimulus. The number is far greater when you consider the additional liquidity provided by international governments and central banks. We have long understood that massive combined stimulus had the ability to fuel some of the longest and strongest bull markets in history.
Experience with stimulus-fueled cycles, combined with the historically transient nature of pandemics, helped give us the confidence to buy aggressively during the most uncertain moments of COVID-19’s global spread.
While market history is clear on the effects of massive stimulus, it is also quite clear on the fate of expensive markets – something else that has long been the subject of this commentary. We had repeatedly discussed the downside risks of high valuations before 2020, and throughout the recovery stocks have only become more stretched.
Of course, there are no market rules so enduring as to warrant an “unstoppable force vs immovable object,” analogy, but unprecedented stimulus in a historically expensive market environment is about as close as you get.
Markets can sidestep the irresistible force paradox, however. Both a liquidity-fueled speculative boom and a valuation-grounded hangover can occur in the same market, just at different points along the timeline.
Since we have seen the largest and fastest liquidity infusion in history, there are legitimate reasons to believe that the speculative phase of the timeline will continue. We had previously believed that the speculative excesses of the tech bubble would not be repeated, particularly in the wake of two 50% crashes within a decade, but this cycle has already surpassed the tech bubble via many metrics.
Some popular measures that have exceeded the tech bubble peak come with reasonable justifications. Market Cap/GDP can be explained away by a global numerator against a domestic denominator. The record high price/sales ratio can be credited to record high profit margins (though you have to hope margins remain at record highs, despite a tendency to mean-revert).
Most recently, and perhaps most concerningly, the percentage of household wealth in equities reached an all-time high. More than these other record readings, this metric has a particularly high correlation with poor forward returns. We strongly believe that the public generally benefits from broader stock ownership, but the public now have a very large portion of their wealth exposed to high-risk assets that are priced at historically expensive multiples. Per percentage point, any pullback from these levels would be the most painful pullback in history.
Investors got a small dose of that reality in September, with the S&P 500 posting its worst month since March of 2020. The weakness dragged down early-quarter gains, capping off the worst quarter since the pandemic-led recession began.
So far, losses have not yet exceeded 5%, keeping market drawdowns rather benign. There are some reasons to view this small pullback as a buying opportunity. Among short-term metrics, we saw a significant jump in bearish sentiment among retail investors, and the quarter ended with the largest 2-week outflow from equity funds this year -- both positive contrarian signals. As mentioned above, monetary infusion cycle dynamics remain a strong justification for buying any dip in equities.
The pullback in prices, combined with these underlying fundamentals, allowed us to take on some increased equity exposure in the third quarter, though we continue to hold onto large cash positions as we wait for higher probability/lower risk entry points.
Though there is a real probability of a continued liquidity-driven bull market, the very elements that deserve the most credit for the gains are rapidly unwinding.
Most of the money authorized under legislated fiscal stimulus has been disbursed. Appetite for large scale infrastructure and spending bills has been tempered by moderate senators and inflation fears. The Federal Reserve, confident in the recovery and also weary of inflation, is planning to rapidly scale back the pace of asset purchases this fall (they already sold off their portfolio of bond ETFs).
Stimulus would be less important if organic growth could continue unimpeded, but a combination of a COVID wave, rising input costs and supply chain disruptions make it likely that the third quarter actually saw a decline in S&P 500 operating earnings – the first quarter-over-quarter decline since the start of the pandemic. It is still possible that positive earnings surprises show continued growth, but the quarter is almost certain to reflect the slowest earnings growth of the recovery thus far.
Many of these earnings issues are likely to be transitory, but they are a reminder that things go wrong. Equities, meanwhile, seem to be priced as if nothing will.
Our preferred market valuation metrics have not risen to tech-bubble levels, but they remain concerningly high. These measures are far above the richest sustainable markets, with the S&P 500 price/peak earnings multiple still 25% above the historical upper limit and more than twice the historical average sustainable ratio.
While we will take action based on shorter-term data, we must remain aware of the fact that these elevated multiples imply elevated downside risks. Even in the event of rising markets, today’s valuations suggest poor risk/return metrics going forward.
Given the tensions between a high-momentum liquidity fueled market and high market multiples, we will continue to generally err on the side of caution. We bought close to record highs in the third quarter, but it will likely take more than a 5% pullback for us to further increase equity allocations.