Q2 2021 Market Update: Signs of a Top

“Those who cannot remember the past are condemned to repeat it.”

                                                                                                                        George Santayana

There seems to be a widespread lack of a historical perspective among investors today. This is particularly common in the late stages of a market mania. People tend to extrapolate recent experience and cannot seem to conceive of a massive change ahead. Even those who do remember prior market cycles rationalize things by arguing that “this time is different.”

It almost never is. Though the companies, technologies, and people are different from cycle to cycle, the behavior tends to be repeated – almost without fail. There needs to be a good story, or “hook,” to entice people to recklessly part with their money. It usually involves a technological breakthrough (such as electricity in the 1920s or the internet in the 1990s) that will transform society. Fervor for the companies that seem likely to benefit surges. Momentum begets more momentum. As more people observe the rising market prices, they want in, with increasing desperation not to miss out.

The hook this time might be the digitization of society (the “Internet of Things” and “Smart Cities”). In addition, the financial system would be transformed by digital currencies (cryptocurrencies), the most prominent of which is Bitcoin.

These could, as with the historic changes brought about by railroads, autos, radios, TVs, personal computers, etc., transform society. But as we saw with the hundreds of companies in those businesses back then, most failed to earn a profit and eventually disappeared.

Again, in the current cycle, the investing public is piling in at what is likely close to a massive market top. There has been the usual binge buying of mutual funds and exchange-traded funds by retail investors after prices have reached nosebleed levels. But this time there also has been the advent of Robinhood, a smartphone app that facilitates free trading. As in other market manias, the COVID lockdowns and huge government payments made the stock market a form of entertainment (partly due to the absence of sports betting early in the pandemic). A reliable personal indicator of speculative behavior used to be when the TVs at fitness centers were turned to CNBC, the business news channel known for hyping the market (known by some as “Bubblevision”), rather than CNN or ESPN.

Another reliable sign of a market top is when the private company that has perhaps most captured the public’s fancy issues stock to the public for the first time through an initial public offering (IPO). Cryptocurrencies have captured the investing public’s fancy this time, and Coinbase, the company that facilitates trading in cryptocurrencies, had its IPO in April. Coinbase (ticker: COIN) shares have already fallen by 45% in price since then (we don’t invest in IPOs). Or it could be Robinhood itself, which plans an IPO soon.

Today’s stock market does seem ripe for an epic decline after an epic rise. What might cause a turning point? We are generally loath to guess, but we see three potential catalysts.

A weaker-than-expected economy

First, the conventional wisdom is that the economy is strong, supply shortages are causing inflation, and the Federal Reserve will have to begin raising interest rates sooner than planned.

We disagree. We think the economy is softening and that GDP growth and corporate earnings in the second half of the year will be much weaker than forecast. Stocks are “priced for perfection,” at the most expensive valuations in 100 years, and investors are “all-in,” with record low levels of available investment cash. And remember, it is unexpected change at the margin that drives market prices. The “reflation trade” already is fading, as economically sensitive sectors have been lagging more stable ones recently.

For example, we hear about “pent-up” consumer demand for restaurants, entertainment, and travel. But we don’t hear about the “pent-down,” or exhausted demand for consumer durable goods, such as furniture, electronics, exercise equipment, appliances, home renovations, autos, and even houses (the bigger the better). Such purchases amount to four times that of restaurants, hotels, live entertainment, etc. As economic reports beneath the rosy headlines reveal, the impact of the (waning) government stimulus is turning out to be fleeting.

This has important market implications. Bonds, as we argued last quarter, were quite attractive, not for current income (with rates still near record lows), but for capital appreciation as market rates fall. That has indeed been playing out, with rapid declines in interest rates in the last few months: The 30-year U.S. Treasury bond yield has dropped from 2.45% to 1.99%, and its market value has risen by almost 10%.

For the stock market, we favor economically stable sectors, including consumer staples, real estate investment trusts (REITs), communications services (telecoms), and health care. Economically sensitive sectors will likely have poor relative performance, as would technology after its historic rise. We also favor stocks with high dividend yields, because given the high historic likelihood of little-to-no capital appreciation ahead, high current income will be relatively appealing.

A drag from China

A second negative catalyst could be slowing growth in China, the world’s second-largest economy. The country also faces a potential credit crisis from looming loan defaults. This could be exacerbated by the government’s tightening of credit to keep the bubble from inflating further. Implications would be reduced demand for commodities (lower inflation), and lower industrial production and global economic growth.

Long-haul COVID economic impacts

Finally, the third catalyst could be COVID’s longer-than-expected economic impact, this time from the Delta (or another) variant.

To sum up, we still like defensive stocks, bonds, and cash – along with put options for clients who are inclined to take a more active role in hedging portfolios against a major decline in the stock market.