Q1 2021 Market Update: Caution: Slippery Road Ahead

Why caution at a time like this? The COVID vaccine rollout is far exceeding expectations, the federal government is pumping trillions of dollars into the economy, consumer and investor confidence levels are high, and the Federal Reserve has set short-term interest rates at 0% and is intervening to support financial markets. The head of the Federal Reserve of San Francisco even stated that the Fed “won’t be preemptively taking the punch bowl away.” (Translation: “Party on!”)

All of that is well known. Investors envision amazing profits. The fact that stocks are more expensive than 99% of the time over the past century is irrelevant. A frenzy to pile in—after spectacular gains have already occurred—mirrors the behavior during prior great speculative manias.

History has shown over and over that such overconfidence creates the most dangerous times to invest. Though high valuations are the most important factor in determining subsequent long-term returns, they alone are usually not enough to cause an immediate plunge in prices. But when combined with extremely high speculative behavior, the result has been a concealed fragility. When the fragility is broken, the frenzy to get in is replaced by a stampede to get out (as we saw just last March).

It is impossible to know in advance what might pop a market bubble. Fortunately, we are not in the business of prognosticating the level of the stock market over the next 12 months. Anyone can make a guess, with varying degrees of success.

We are, however, in the business of investment risk management. This is a business of probabilities, of weighing potential returns versus risk, and we rely heavily on market history and on buying undervalued assets. In general, we think that the U.S. stock market offers relatively few current profit opportunities that justify the extreme historical market risk. There are, however, exceptions, particularly in the consumer staples, communications services, REIT, and health care sectors. We have purchased shares in solid companies (generally foreign) that are depressed and poised for positive change (e.g., due to a new CEO or a revitalized business strategy). In the meantime, it seems prudent to hold abnormally high levels of cash for superior opportunities that we expect will arise.

As we observe economic developments, we look beneath the headlines. Many economic measurements are taken at face value. Investors seize the latest data in the hope of gaining a market edge. Yet those measurements are very crude attempts (which are often revised substantially) at measuring an extremely complex economic and financial system. We see that, for example, in the government’s monthly employment report or in the measurement of gross domestic product (GDP). Take them with a large grain of salt.

While we remain cautious about the stock market, we have become more enthusiastic about bonds lately, despite historically low interest rates. In recent months, amid surging optimism over the lifting of COVID restrictions and for an expected economic rebound, investors have priced into markets a substantial increase in inflation and interest rates. We disagree about the likelihood of near-term inflation.

Though over the next several months the reported rate of inflation will be much higher in comparison to the levels of a year ago (during the depths of the COVID shutdown), those effects will likely be transitory. We do not anticipate a material sustained increase in labor costs. Output per hour is the most important cause of lasting inflation, and substantial investments made last year resulted in a sharp increase in productivity.

Inflation might be an issue later, though. The levels of federal government spending and Federal Reserve money printing are unprecedented. We have written about Modern Monetary Theory (MMT), which essentially says that a government that borrows using its own currency (rather than that of another country) can borrow almost without limit—so long as there is slack in the economy (as there is now). MMT is no longer just a theory. It is now effectively U.S. government policy, and we will see how it turns out. It is a high-stakes experiment.

We expect the effect of the government’s stimulus spending to be transitory, and we—unlike a substantial number of commentators—do not expect this to be a repeat of the Roaring ’20s that followed a historic pandemic a century ago.

While all this plays out, we as citizens are uplifted by the early actions of the Biden administration on climate change and racial justice. As investment professionals, we remain vigilant on our clients’ behalf.

Your Clean Yield team,

Dorigen, Elizabeth, Eric, Karin, Mary Lou, Molly, Steve, and Walter