Weekly Perspective: The Ox, The Ostrich, and The Outrage

The Ox

There is an old anecdote that is often used in introductory finance and economics courses to display the power of free markets as efficient allocators of capital.  It begins with Sir Francis Galton at a county fair in 1906.  He observes a contest where 800 participants were asked to guess the weight of an ox. He examines the data after the contest and finds that most participants were way off of the mark, but much to his surprise, both the mean (average) and median guess were within 1% of the ox’s actual weight of 1,197 pounds.  Thus, the idea was born that markets are an efficient way to determine prices, given individual participants can be wrong but that the collective judgment gets you pretty close to an accurate assessment of value.

But what happens if a group of fairgoers decides to band together to guess higher weights for the ox (maybe they’re fighting against a kind of 4-H cabal that is low-balling the weight of their oxen).  This group lobs their bets in and instead of mean weight of 1,197 pounds, the crowd now indicates that the ox weighs 2,000 pounds.  Did the ox miraculously gain 800 pounds? No.  Is the crowd still “wise” and “efficient”? Clearly not.

This idea raises an important condition for markets to be efficient. In his The Wisdom of Crowds, James Surowiecki also recounts this original Galton anecdote, but in his asserting that “large groups of people are collectively smarter than individual experts” the key requirement is that the large group of people is made up of a “diverse collection of independently deciding individuals.”

When our group of disgruntled fairgoers bands together to push up the weight estimate, they are not acting individually, and thus they are skewing the efficient and “wise” averaging mechanism of the market.  Surowiecki makes the important distinction that the power of independently deciding individuals is very different than crowd psychology, which is well known to descend into periods of madness and delusion (as detailed in Charles Mackay’s 1841 Extraordinary Popular Delusions and The Madness of Crowds).

So, in today’s market of soaring stock prices for unprofitable companies, the proliferation of nose-bleed valuations, ravenous risk-taking and leverage, and message boards that whip members into an emotional frenzy to “GET IN AND HOLD!” in order to exact revenge on the “establishment”, have we descended from the Wisdom of Crowds to the Madness of Crowds?  We think yes.

Of course, here’s our caveat on repeat: these effervescent conditions can persist and intensify, meaning there’s little timing signal that can be gleaned from observing bubble behavior.  Identifying a bubble is different than identifying a market top.  The former can be sustained for some time, while the latter directly involves a time factor, which makes it all the more difficult to predict.

So how do we navigate this environment? By using every arrow in our quiver.  In times like these, fundamental analysis can tell us that an asset is overvalued, but it provides little help to determine how or when the asset price will move back towards its inherent value.  This is when we turn to the market prices themselves and behavioral finance (collectively known as technical analysis) in order to traverse the risky terrain.  This is done with the intention of fighting emotional urges to “get in on” the riskiest aspects of the market action and not getting drawn into dangerous market narratives that aim to justify today’s valuations.  And this is where the ostrich comes in.

The Ostrich

Federal Reserve Chairman Jerome Powell hosted a press conference last Wednesday following the Fed’s two-day policy meeting.  The press conference happened just as the GME saga was unfolding in the market (see FT article here for a play by play), which led to questions about if the Fed was concerned about valuations and bubble-like conditions in the market, and if the Fed thought that its policy was contributing to these observations.  Powell’s answer was an emphatic “no” stating that:

“The connection of low-interest rates to asset prices is probably not as tight as people think.”   

Outside of the simple theoretical (discounting future cash flows) and empirical (correlation of valuations and interest rates over the long term) pushbacks to this assertion that interest rates don’t matter for valuations, someone should show Powell Chart 1 below.  It illustrates the tight relationship of sky-rocketing valuations for the NASDAQ (red line) and plummeting real yields (black line, inverted).  This surge in long-duration stock valuations started in late 2018 with the “Powell Pivot”, when he “blinked” in the face of the December 2018 market meltdown and backed away from the tightening of policy, putting downward pressure on interest rates and allowing tech-like valuations to soar.

Chart 1: NASDAQ PE Ratio (red line) and U.S. 10-Year Treasury Real Yield (black line, Inverted)

_{Source: Bloomberg, Fieldpoint Private}

We also note that Powell appears to be trying to have it both ways, because prior to saying that interest rates don’t matter for valuations in this January meeting, recall that in the December meeting Powell said that low-interest rates were what was justifying current high valuations (we detail this in our December 21, 2020 update, “The Fisher Fed”).

“If you look at PEs, they’re historically high. But in a world where the risk-free rate is going to be low for a sustained period, the equity premium, which is really the reward you get for taking equity risk, would be what you’d look at. And that’s not at incredibly low levels, which would mean that they’re not overpriced in that sense. Admittedly, PEs are high, but that’s maybe not as relevant in a world where we think the 10-year treasury is going to be lower than it’s been historically from a return perspective.” -Jerome Powell, December 16, 2020 (full transcript)

The Fed is clearly taking the ostrich approach to questions of financial stability and asset valuations.  Yes, the economy is still on shaky ground (the recovery has lost steam over the past couple of months), while unemployment remains elevated and inflation elusive justify an easy policy stance on the surface.  But with stock valuations nearing prior bubble highs, plenty of signs of speculative excess, and now home prices increasing at a faster pace than even during the housing boom (see This Week’s Data section below), at what point will the Fed have to seriously contemplate questions of financial stability (given the bursting of bubbles can be deeply damaging)?  This brings us to the outrage.

The Outrage

During last week’s Reddit trading whirlwind, we were struck by the level of vitriol that was expressed by retail traders participating in the short and gamma squeezes across the market.  There were rallying cries that these trades were intended to take down the Wall Street establishment (see opinion article here), and sheer fury when buying was prohibited in the most squeezed stocks (see FT article here; turns out this was due to brokerages falling short of capital ratios and clearing houses increasing margin requirements, see WSJ article here).  Though this current behavior is likely more driven by the gambler’s high of winning it big than burning down the system (see Bloomberg article here), in a micro sense these professions of anger and revenge testimonials do serve a purpose in making these trades work.  Each one of these expressions comes with a directive to readers to HOLD and not sell, ostensibly in an effort to prevent everyone from rushing to the exit all at once to cash in on huge gains, which would likely send prices crashing.  This also inspires latecomers to join the protest trade (and likely play the role of the greater fool).

But there is a macro take-away from this anger as well that should not be ignored.  Despite rising incomes and greater societal prosperity overall, anger is clearly on the rise.  Eric Lonergan and Mark Blyth detail this dynamic in their book Angrynomics, looking at the rise in anger, protests, and populism in countries around the world.  They propose solutions to quell this anger that probably appeared radical when they were writing the book pre-pandemic: direct payments to individuals during recessions to dampen the hit to consumer spending, large fiscal deficit spending gave the air cover of low-interest rates/low debt servicing costs, and environmental-focused infrastructure investment, to name a few.  But after 2020, these solutions seem necessary and normal to voters.  To further see this shift, in his new book Geopolitical Alpha Marko Papic argues that the preference of the U.S. “median voter” has now moved from laissez-faire market policies and deficit controls to a full embrace of interventionist and deficit-fueled fiscal support.  He predicts that this will lead to a weaker dollar and the underperformance of U.S. assets in the next long-term cycle.

With the U.S. seeing bubble-like conditions, very elevated valuations, and a long period of massive outperformance, we have been arguing for clients to start slowly paring back on what are likely big overweights to domestic markets and to start slowly increasing allocations to select international markets.  The dollar is the fulcrum for this rotation and though we could see long-term downward pressure on the dollar, the short-term upside could continue given positioning is dominated by bearish bets currently.  As these positions unwind, dollar strength could give investors an opportunity to continue this slow rebalancing process towards assets that benefit from a weaker dollar in the long run.

Last Week in Markets: Equities Worst Week Since November, Long Bond Yields at Support, #silversqueeze

Equities

U.S. large-cap equity markets had their worst week since November (S&P 500 -3.21%, NASDAQ -3.49%, and Dow Jones Industrial Average -3.27%).  In total for January, the S&P 500 (-1.11%) and Dow ( -2.04%) are down on the year, while the NASDAQ is slightly positive (+1.42%).  The positive or negative performance of January has predicted the annual S&P 500 positive or negative return 70% of the time.  Volatility spiked on the week, with the VIX +51% to 33.09.

Smaller cap sizes underperformed last week (Russell 2000 Small Cap -4.39%, and S&P 400 Mid-Cap -4.97%), despite massive rallies in some of the index constituents.  Bloomberg’s Cameron Crise did an analysis showing that on Wednesday almost 2% of the Russell 3000 Index rallied more than 10%, despite the S&P 500’s 2.5% drop, a clear sign of market dislocations.  He notes that this degree of sharp small-cap rallying during large-cap drops has only happened at the peak and in the aftermath of the tech bubble, during the GFC, and in the midst of the coronavirus meltdown in March 2020.

Growth (-3.36%) slightly outperformed Value (-3.49%), while all sectors were negative for the week, but there was clear outperformance of Defensives over Cyclicals.  The best performing sectors were clearly defensive: Real Estate (-0.15%), Utilities (-1.15%), Staples (-1.56%), and Health Care (-2.19%).  While the weakest sectors were cyclical: Energy (-6.62%), Materials (-5.3%), Financials (-4.6%), Consumer Discretionary (-4.42%), and industrials (-4.2%).  Other cyclical groups like Semiconductors (-6.09%), Transports (-4.42%), and Banks (-5.42%) also underperformed.

This weak trading continues to come as earnings come in above expectations.  Over the last two weeks, we have warned about this divergent dynamic that strong earnings don’t guarantee strong stock performance, mostly when valuations, expectations, and optimism are so high (see here and see here).  According to FactSet, 37% of S&P 500 companies have reported 4Q20 earnings, with 82% beating estimates by an aggregate amount of 13.6% above estimates.  Earnings are now tracking down -2.3% YoY for 4Q20, which is better than the -9.3% expected at the end of the quarter.  Revenue growth for the S&P 500 is actually tracking positively for the quarter +1.7% YoY.  We can see in Chart 2 how, despite big beats to earnings consensus, the day one reaction by companies is negative for nearly all sectors

Chart 2: Stocks Responding Negatively to Earnings Beats (as of 1/29/21)

_{Source: Bloomberg, Fieldpoint Private, as of 1/29/21}

Fixed Income

Rates edged slightly lower on the week given the risk-off backdrop, with the 10-Year Treasury -2 bps to 1.07% and the 2-Year down less than -1 bps to 0.11%. The 10-Year is just holding its upward trend, with 1% an important “line in the sand” (the 10 Year briefly hit 1% on Wednesday, see Chart 3).  Interestingly, despite the expectations for higher stimulus and deficit spending, analysts expect the Treasury to dial back Treasury issuance over the next couple of months due a high cash balance to start 2021.  A drop in Treasury issuance could possibly remove the upward pressure on yields that increased supply sometimes creates (see article here).  The amount of additional stimulus remains uncertain given Democrat’s slim congressional majority and some Democratic party members expressing doubt that the headline $1.9T of additional stimulus is necessary.  Wall Street consensus is for 10 Year yields to rise to 1.3% in 2021, still lower than the 1.6% seen at the start of 2020 pre-pandemic.

Chart 3: U.S. 10-Year Treasury, Just Holding Support, 1% Level Important

_{Source: Bloomberg, Fieldpoint Private}

Currencies and Commodities

The U.S. Dollar (DXY) was slightly stronger on the week (+0.38%) to $90.58 given the risk-off sentiment.

Commodities were mixed on the week, with a fair amount of volatility.  WTI Crude declined -0.13% to $52.20, while Natural Gas rallied +4.82% on winter weather.  Copper prices were weaker (-1.93%), while Iron Ore was stronger (+1.54%).  After a sell-off the week prior, agricultural commodities staged a comeback last week (Core +9.25%, Soy Beans +4.44%), as the news of China’s large purchases from two weeks ago was reflected in crop prices.

Precious metals were mixed with Gold down (-0.43%) but Silver up (+5.86%).  Silver appears to be the next target for the “Reddit Raiders”, with the Internet alight with hopes of spurring a #silversqueeze (see Bloomberg article here).  Friday saw a nearly $1B inflow into a silver ETF, almost double the previous record from 2021, sparking an 11% rally off of Wednesday’s low.  Over the weekend, there appeared to be a run on physical silver, with silver coin sites stopping to process orders due to unprecedented demand (see Bloomberg article here, though Eddie van der Walt of Bloomberg also points out that it is very common for coin shops to run out of metal).  The #silversqueeze is trying for a repeat of the last week’s retail-store trade, and not to say the rush of retail money into the market won’t have a short-term impact (as of Sunday evening Silver futures have opened up 7%), it is important to remember that the silver market is 200x larger than that retail-store, and the relative short interest is nowhere near as large for silver ETFs compared to float or trading volume.  Silver’s Short Interest Ratio, short interest divided by the day’s average trading volume, is a mere 0.59x as of 1/15/21 compared to retail store’s 6.1x as of 1/1/21 and 26.1x in the summer of 2020, when talk of that trade first started to pick up speed.  Regardless, the rhetoric surrounding the trade is interesting, as it combines the now-familiar mix of gunning for big trading gains, conspiracy theories, and protecting against and/or taking down “insider” institutions.  The #silversqueeze proponents are aiming to protect against money-printing governments through real assets and wanting to “destroy” big banks, which they claim are heavily short silver and will be unable to fulfill physical delivery once the Redditors have bought all of the physical silver available… (see article here).  As of Monday morning, we’re already starting to see fraying at the edges of the trade, with the original #silversqueeze post removed by r/wallstreetbets moderators, while a follow-up post argued the conspiracy theory-driven silver trade idea was a conspiracy itself of hedge funds to distract Reddit crowd from its stock squeezes… You can’t make this up. Tread carefully.

Last Week Economic Data: GDP, Manufacturing Strength, and House Prices Rising Faster Than During the Housing Bubble

4Q20 GDP and Components

U.S. GDP for the fourth quarter of 2020 came about in line with expectations at +4% annualized (+1% quarter-over-quarter).  This was a large, but expected, slowdown from 3Q20’s +33.4% annualized growth rate.  GDP for the full year 2020 was -3.5% (see Chart 4).

Chart 4: Annual Real GDP Growth

_{Source: Bloomberg, Fieldpoint Private}

Chart 5 shows the components of GDP by quarter.  There are a few things to note here, Consumer Spending growth has normalized after the sharp snap back in 3Q20.  Inventories remain tight and the rebuilding of inventories is adding to growth (likely due to strong goods demand, discussed below).  Net Exports (Exports minus Imports) has been a drag on growth for the second quarter in a row due to strong demand for imported goods.

Chart 5: Components of Quarterly GDP Growth

_{Source: The Daily Shot}

Within the Investment component, we can clearly see the shift from the physical to the digital economy, plus the strong demand for residential investment. Chart 6 shows how Non-Residential structures continue to languish (who is building a new office or hotel right now?), while Intellectual Property (think software) has remained resilient.  There’s been a strong bounce-back in Non-Residential Equipment, likely partially helped by the strong manufacturing and goods demand.  Residential investment has seen the most powerful rebound.

Chart 6: Components of Investment Portion of GDP, Residential the Strongest

_{Source: Bloomberg, Fieldpoint Private}

Within the consumption component, 2020’s recession and recovery off the lows was particularly unique in that it saw a strong rebound in Goods demand (+6.5% YoY in 4Q20 and +6.9% YoY in 3Q20 after falling -3.5% in 2Q20) while Services demand has remained weak (-5% in 4Q, -5.5% in 3Q, and -12.5% YoY in 2Q20).  Usually Services are much more resilient and faster to recover post a recession than Goods, but given social distancing requirements and changing consumption patterns (investing in homes and cars as people move out of cities, for example).  See Chart 7 to see this dynamic during the COVID recession and compare it to the GFC recession, where Goods demand shrank for over a year, while Services demand growth never went negative.

Chart 7: Personal Consumption of Goods (Black) vs. Services (Orange) YoY

^{3 Year}

^{20 Year}

_{Source: Bloomberg, Fieldpoint Private}

Personal Income Growth continues to be in positive territory, despite the sharp drop in employment.  Chart 8 shows the spike in personal income growth with the initial stimulus support.  Analysts expect another boost in YoY personal income growth with incremental stimulus. Chart 9 from BlackRock shows the “excess saving buffer” with the gap between disposable income and consumption spending in 2020.

Chart 8: U.S. Personal Income YoY- Big Bounce Following Initial Stimulus Checks and Unemployment Support, Which Allowed Income to Defy the Drag from Lower Employment/Wages

_{Source: Bloomberg, Fieldpoint Private}

Chart 9: U.S. Income vs. Consumption- Savings Provide a Buffer for Future Demand

_{Source: BlackRock Investment Institute}

Manufacturing

Though we get the national ISM manufacturing survey on Monday, last week gave us regional manufacturing reports that show continued strength in the sector. This is likely boosted by the strong demand for goods and tight inventories that we explained above.  For example, the Kansas City Fed Manufacturing Index came in above consensus (17 vs. 13 cons; above 0 is expansion, see Chart 10), with Production and Input prices moving significantly higher: The Prices Paid component soared to 63 (above 50 is expansion) as tight inventories and rising commodity/shipping costs put significant pressure on prices (see Chart 11). Surges higher in prices paid data in manufacturing is leading some analysts to expect higher inflation readings in the near future (while others argue that weak Services inflation will keep a lid on the aggregate number).

Chart 10: Kansas City Fed Manufacturing Index

_{Source: Bloomberg, Fieldpoint Private}

Chart 11: Kansas City Fed Prices Paid Index

_{Source: Bloomberg, Fieldpoint Private}

Home Prices

The Case-Shiller National Home Prices Index for November showed a 9.5% increase in YoY home prices (vs. 8.85% cons), see Chart 12.  The U.S. Federal Housing Finance Agency sees home prices increasing 11% YoY (see Chart 13), which is a higher rate of increase than during the housing bubble!  Given the Fed’s commitment to keeping interest rates low, we think continued rapid increases in home prices will be a key watch item for future Fed policy moves (could rapid home price increases cause the Fed to reduce accommodation earlier than it would like on just an employment and inflation basis?).

Chart 12: Case-Shiller 20 City Composite Home Price Index YoY

_{Source: Bloomberg, Fieldpoint Private}

Chart 13: Growing Faster Than the Housing Boom- U.S. Federal Housing Finance Agency Purchase Only House Price Index

_{Source: Bloomberg, Fieldpoint Private}

This Week Data: Manufacturing, Jobs

A busy week ahead with manufacturing and jobs data in focus. A further 100 S&P 500 companies will report 4Q20 earnings.

• Monday: Institute for Supply Management Manufacturing Purchasing Manager’s Index (ISM Manufacturing PMI; Construction Spending
• Tuesday: No major reports
• Wednesday:  ISM Nonmanufacturing (Services) PMI; ADP National Employment
• Thursday: Weekly Unemployment Claims; Factory Orders
• Friday: Jobs and Unemployment, Trade Balance, Consumer Credit

 

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