'What could go wrong?'
Excess euphoria? Politics? Inflation? Always good to ponder.
Always good to ponder, wouldn’t you agree? Consensus is this will be a strong year for stocks, as major indexes keep hitting new highs, earnings forecasts keep rising and new IPOs are arriving at a frenzied pace. A complete turnaround from a fear-laden March 2020—now a distant memory. Almost every sentiment indicator—AAII bulls-bears, the put-call ratio, CNN’S Fear and Greed Index, among others—reflects excessive optimism. Everyone is bullish. In his 25 years of market watching, Deutsche Bank strategist Jim Reid “can’t remember a time when so few—if any—dispute the central narrative.” Hmm. Shouldn’t we be wary of the crowd at extremes? Meanwhile, there’s the virus, and potentially a bumpy vaccine rollout/recovery. A key premise behind rising market and profit forecasts are an economy that snaps back in a big way in the second half, with shut-in-weary consumers rushing to shop in stores, dine in restaurants and vacation again. And yet Covid-19 cases remain elevated, vaccinations have been sluggish, a more contagious second strain is spreading, lockdowns are back, consumer expectations are deteriorating and masks/social-distancing measures seem almost certain to extend into summer if not beyond. There are still roughly 10 million fewer people on nonfarm payrolls today than a year ago. Reaching peak profitability with 6% fewer workers would require an almost Herculean enhancement in productivity—not impossible, Strategas Research says, given the pandemic-led acceleration in utilizing new technologies. This would leave a significant portion of the labor market facing structural unemployment and would represent a drag on future growth.
How about China, the world’s second-largest economy? Its acceleration is expected to be a global tailwind. But China appears to be transitioning from recovery/stimulus to policy tightening, with a focus on its own economy. Credit expansion there already has peaked. Inflation? It’s hard to dismiss this when money supply is growing at a 24% annualized rate, the value of the assets on the Fed’s balance sheet jumped 70% in two months, the dollar continues to weaken and Democrats (who want more stimulus money) now control the White House and Congress. Core PCE likely will bounce above 2% in the spring as its laps the weakest pandemic base effects, and then subside. But what if asset prices keep running hot? We are starting to see markets bake in the possibility of higher inflation, with breakeven rates breaking out. The most important swing factor in core CPI, the cost of shelter, is facing pressure amid soaring demand for housing against a backdrop of tight supply, rising household formation rates and a desire for more space. Manufacturers are seeing pressures build, too. The ISM manufacturing prices-paid component jumped to a 3-year high in December. Just four of 58 Wall Street economists surveyed by Bloomberg have a year-end 10-year Treasury yield forecast above 1.50%. A 2-handle on the 10-year? Neither the bond nor stock market will like that.
A correction from current levels wouldn’t be a surprise. While stocks typically are higher in months 10 through 18 off a major low, the trajectory tends to be volatile. The 9-month rally off the March 23 bottom is rivaled only by the first nine months after the August ’82 and March ’09 lows, after which both subsequently experienced a challenging nine months. Most investors were fully invested through Q3, Fed data show, before Q4’s run. Ned Davis notes equity allocations are now above 2000’s dot-com and 2007’s housing-bubble peaks. Shouldn’t we be wary at extremes? And then there’s politics. With the Dems now controlling the legislative and executive branches, we can’t rule out higher taxes, tougher regulations and attempts to dramatically ramp up spending on such big-ticket progressive items as the Green New Deal and Medicare for All. What could go wrong? Always good to ponder.
What could go wrong? Since the Volcker years, the Fed has done a pretty good job of remaining independent, save the 2008 financial crisis when its balance sheet ballooned from $800 billion to $4 trillion, and the Covid crisis, which pushed the balance sheet to $7 trillion. Now comes ex-Chair Yellen, the new Treasury secretary who is advocating for more stimulus.
Shouldn’t we be wary of the crowd at extremes? After studying the habits of the new app-traders, Empirical Research discovered “Big Growers,” the 75 stocks with the best all-around growth credentials, significantly overrepresented in portfolios, comparable to readings at Nasdaq’s March 2000 peak. How do these retail investors find stocks to buy? The same way they find everything else: they Google it.
Shouldn’t we be wary of the crowd at extremes? Relative to historical long-term trends, the market looks extended, Ned Davis says, just not as much as in 1929 and 2000. Momentum and new highs vs. new lows argue a cycle peak remains in the distance, with the burden of proof on the bears.