Updated: Feb 17
When asked what it takes to win a Nobel prize, Francis Crick said,
“Oh, it’s very simple. My secret has been I know what to ignore.”
Major US Equity Indexes ended Q3 broadly flat as declines in September erased prior gains. September was a tough month for equities, with the S&P 500 losing 4.8% and ending its seven-month winning streak. This pullback serves as a reminder that volatility is expected and normal in the stock market.
Sell-offs in China, as a result of the Evergrande default and an ever-increasing clamp down on big tech, had a contagion effect on the broader Emerging Market, pulling EM equity significantly lower for the quarter.
Global bond yields were little changed with all eyes now on the US federal reserve as they reduce their bond purchasing program. The Feds tapering measures will reduce monthly Treasury and mortgage-backed securities purchases by $15 billion, starting this month. The Fed’s $120 billion per month bond-buying program will be fully unwound by July 2022, giving way to the elusive next step, rate hikes.
Asset Class Performance Q3 2021
As the month ended, major U.S. stock indexes rose for the fourth week in a row to make it a clean sweep for markets in October. Concerns about inflation, supply-chain issues, and fiscal and monetary policy direction all weighed on mood in September, but the bulls have regained their strength in recent weeks as the market bounced back thanks to solid earnings and strong consumer sentiment. The major U.S. stock indexes finished the month up between 5% to 7%.
Asset Class YTD Performance 2021
WHERE DO WE GO FROM HERE?
Financial media loves to play the pessimist, endlessly proclaiming that 'the end is nigh'. Sure, headlines detailing the imminent demise of financial markets make for enticing titles, but little else. The same quotes have been circling since 2017, calling for an end to the market madness, and they seem hell-bent on leaning into this broken clock strategy until they finally get it right. For those who care to dig a little deeper, this 'imminent demise' seems far less likely, and optimism looks set to trump pessimism for some time to come.
This idea that prices are higher than they have been before and therefore must surely mean revert to previous historical levels is overly simplistic. While the law of gravity states that what goes up must come down, the laws of economics are a bit more ambiguous.
Although the use of the phrase 'This time is different' is utter sacrilege within investing circles, there are important forces at play that need to be factored in to debunk this idea that a crash is just around the corner for equity markets.
The Fiscal and Monetary stimulus effects have been well documented at this stage. Since the start of the pandemic, the Federal Reserve has added more than $4 trillion to its balance sheet through its open-ended quantitative easing program, while the U.S. government has unleashed over $5 trillion in fiscal stimulus.
Fed Balance Sheet Expansion
Over 40% of the money that has ever been printed in the history of the US dollar, was printed in 2020.
This expanded balance sheet has considerable effects on the wider market for a number of reasons.
A Healthy Consumer
Since the end of 2019, US household net worth has increased by 25 trillion. Savings accumulated during the lockdown, stronger equity performance, house price increases, and money creation have left American households in a much stronger financial position when compared to pre-pandemic figures.
“Whereas the Great Financial Crisis (GFC) saw the destruction of household net worth (the bursting of a housing bubble) of about 70% of GDP in the 3 years through mid-2009, laying the ground for liquidity trap-like conditions, the Great Pandemic has seen household net worth increase about 120% of GDP in about half the time.” Chris Marsh – Money: Inside and Out
The money created during the pandemic, together with the valuation gains on other assets, has the potential to drive an exceptionally strong recovery.
The Only Game in Town
Extensive Government bond-buying programs have suppressed interest rates in recent years and with rates now close to zero, investors are being forced further out on the risk curve.
This erosion of the risk-free rate leaves equities as the predominant major asset class for investors. This TINA (There Is No Alternative) dynamic in the market has led to unprecedented inflows into equity markets.
Over the first 31 weeks of the year, Global Equity funds have seen $605B of inflow.
Over the last 25 years, Global Equity funds had seen $727B of cumulative inflows.
At current rates, inflows over 2021 are on pace to be 40% higher than the prior 25 years combined.
Global Equity Inflows By Year ($bn)
Source: Goldman Sachs Investor Research Division
In short, you are left with an ever-growing supply of money chasing a finite number of financial assets. Market forces of supply and demand will likely persist to support asset prices further.
While it’s easy to make comparisons between current market levels and the Tech bubble of 99. One pivotal point seems to be overlooked. The equity risk premium.
During the 1999-2000 period, the 10-year treasury was 5–6% which meant you could take a relatively risk-less position and earn more than the yield in the equity market. Needless to say, this is no longer the case.
While equities may seem expensive at first glance, the equity risk premium (excess return earned by an investor when they invest in the stock market over Treasuries) is still attractive at +5.5%.
In investing, opportunity cost is the driving force behind the majority of decisions. Everything is relative. While it may be tempting to compare individual investments across various time periods, Ignoring the differences in the investing environments over these periods will ensure that any conclusion you come to is essentially redundant.
Just to be clear, there is undoubtedly over-exuberance in certain pockets of the markets. A dead video game company, a meme coin of a dog and a meme coin of a meme coin have been some of the most successful trades in recent history, so to say that there aren’t some frothy aspects to the market is simply naive, but this speculative activity is not representative of the entire market and broadly speaking, opportunities will persist.
While key indicators favour a positive outlook over the coming months, pending tapering measures from the Fed and other major central banks could negatively impact equity markets over the longer term.
Equity markets have moved in lockstep with the Feds balance sheet ever since QE was introduced in 2009.
From January 2009 to December 2014, the Fed's balance sheet expanded at a 12% annualised rate. During this time, the stock market rose at an annualised rate of 15%.
From 2009 to 2015, the level of the Fed's balance sheet and the S&P 500 moved in tandem. When the balance sheet stopped expanding in 2015, so did the stock market.
Since the start of the pandemic, the Fed's balance sheet has grown at a 38% annualised rate. This is comparable to the S&P 500's annualised increase of 44%.
Remarkably, the correlation between the size of the Fed's balance sheet and the level of the S&P 500 over the last 12 years is 0.90.
Follow the Fed
With the largest buyer of treasuries exiting the market, we could see increasing upward pressure on interest rates. As a consequence, equity valuations may come under pressure.
While these changes won't occur overnight, higher longer-term interest rates may offer an alternative to equities for investors looking to take some risk off the table.
Sounds just like old times.
The Final Word
While the mammoth growth rates we have become accustomed to over the past 18 months will be impossible to maintain, equity market strength is likely to persist.
With stocks still representing the only game in town for many investors, more money than ever sitting on household balance sheets and the equity risk premium still attractive, the relentless bid looks set put a floor under any pending dips and support markets into the future.