Dear Clients and Friends,
September was the first month in a long time that markets experienced a reasonable pullback as the S&P retreated over 4.5%. It’s been so long that most people seemed to forget that this is not an unusual occurrence. The reasons for this could have been the debt ceiling concerns, China Evergrande contagion, rising interest rates which could negatively impact valuations or a combination of all of the above.
The update below will likely read like others over the past year and I fear I’m starting to sound like a broken record with respect to inflation and market valuations. But alas, I shall continue until something changes!
Markets
Bank of America’s clients as a % of assets reached a record recently at 65.3%. In a world with low interest rates, it’s not surprising to see firms advise clients to hold more stocks.
Bank of America is forecasting negative returns for the S&P 500 in the next 10 years and they are not the only one. We’ve highlighted how valuations have been very predictive of future returns. Quite simply, the higher the valuations the lower the forecasted future returns. Given that PE ratios and other valuation metrics are in the top 10% percentile, it’s not surprising to see predictions like this.
As we mentioned above, PE ratios in the US are extraordinarily high. Emerging markets CAPE ratio is materially lower.
The top 5 companies in the S&P are almost 25% which means you obtain less diversification than ever before. Shares of Facebook, Amazon, Alphabet, Apple and Microsoft added significant returns to the S&P and almost doubled the performance of the index.
Back to valuations for a moment. Below is a chart by Charles Schwab showing various valuation metrics relative to historical levels. Other than a few metrics which mainly revolve around comparing equity valuations to treasury and corporate bonds, all metrics are reading very much in the red.
Almost half of the companies in the S&P 500 are now citing inflation increases on their earnings calls.
Interest rates charged higher on fears of higher inflation which we believe was a contributing factor why equity markets fell last month. Most investors have been taught that owning bonds can act as a hedge against falling equity markets. However, equity markets at this stage require low interest rates to maintain their high valuations so it’s plausible (and even likely) that we can see bonds and stocks deliver negative returns.
Below is another chart from Charles Schwab showing returns for various income oriented investments, mainly bonds. In my opinion, the risk/reward of bonds doesn’t look very appealing and most investors agree if you look at their allocations to stocks vs. bonds.
The number of crypto currencies have proliferated over the past few years and now number over 6,000! It’s hard to tell on the chart but the # doubled from 2020 through today which is incredible.
No surprise that crypto users are up dramatically over the same period of time. I’ve seen this comparison where they look at internet users relative to crypto users and I’m not sure this correlates to future growth tbh. I think we all would agree that the potential growth of crypto “could” continue if it was widely adopted. Whether this comparison holds water is too early to tell.
Bitcoin is more volatile than stocks going back to January 2019 but most people already know that. The severity and speed of drawdowns can be stomach wrenching so be careful and tread lightly.
Professionally-graded sports trading card prices (PWCC Index) have significantly outperformed vs. the S&P 500 since 2008. In fact, the PWCC was sideways before jumping 2015 and surging most recently in COVID. I recall Michael Jordan rookie PSA 10 rated cards going from $150K to $750K in a matter of months. We looked at a fund that collected cards but couldn’t get my head around investing at current levels.
Hedge funds are elbowing their way into Silicon Valley at an unprecedented rate with a record smashing $153B worth of investments in private companies in just the first six months of 2021. A report from Goldman Sachs has found that hedge funds have done 770 deals so far this year, already beating the record number of deals set in the whole of 2020, when 753 deals reached a total of $96B.
Economic Data
The Blue Chip and Atlanta Fed consensus for Q3 GDP has fallen materially since the beginning of August. Both were forecasting GDP above 6% and the Atlanta Fed’s prediction is now approaching 3%. That’s a material downgrade in a matter of weeks…
M2 surged during the pandemic as
According to the Richmond Fed indices, prices are going up for everyone.
This slide from Charles Schwab highlights inflationary pressure from ISM, US rent index from Zillow, average hourly earnings and small business price plans. It’s hard to find places where inflation isn’t moving higher. My greatest concern is one for a stagflationary environment where GDP growth is lackluster while inflation is high. What would that do to stock prices 🤔?
The Case-Shiller home price indices are up approximately 20% year over year as home inventories approach historic lows.
Rent is also going up which is to be expected as home prices rise. Owner’s equivalent rent is used in the CPI and is measured as the rent a home owner could obtain if they decided to rent their home. This metric has understated inflation in recent years and will be watching this closely as it can cause the CPI to jump.
Commodities
Commodity prices are moving higher and natural gas is a standout. As you can see below in the UK, prices there are going parabolic. The energy sector in general is suffering from underinvestment and lower capex which is causing supplies to drop globally. I will highlight this phenomenon in the next few slides. Be prepared for your energy costs to spike materially this winter, especially if we have a colder than usual season.
Baker Hughes US rig count has not recovered from the pandemic plunge which is causing supplies to continue to trend lower. This continues to support higher oil prices.
As I mentioned above, spending in the energy sector has declined materially since 2011-2015 as oil prices fell. I fully expect that higher energy prices are not temporary and we should expect this reality for many years to come. One reason why investment has been lackluster is the ESG movement and a move towards investments by these companies into green projects.
What’s This All Mean?
My concern is an environment where inflation is sticking around and we’ve established a new baseline for prices, even if inflation going forward is reasonable. What I mean is most assets just experienced a price increase that we might not see come back down such as cars or real estate. The go-forward inflation is likely to be lower than we just experienced and we may have established a new baseline. Whether this is the definition or not of transitory is up to you but I don’t expect prices to drop anytime soon.
I see wages are rising everywhere from taking orders at fast food to startups wanting to hire and scale. Good talent is hard to come by and businesses have a lot of roles to fill. Commodities, housing, auto and prices for just about everything have gone up. Profits margins for S&P 500 companies are very high and interest rates currently still very low which the market needs to justify its current high valuations. A shift in one or both of these could send stocks down and leave equity investors nursing losses at a time when allocations have tilted in favor of risk due to TINA (there is no alternative).
All of this leads me to continue to advise caution.
Just as working out without a spotter can be dangerous, investing without an “investment spotter” can be equally detrimental. I’m available if you need a spot.
I hope you found this month’s update helpful and informative.
Best Regards,
Jared Toren
CEO & Founder
Most Used Sources: Edges & Odds, WSJ Daily Shot, 361 Capital, Steve Blumenthal’s On My Radar
