The Stock Market is Bubbling: What Investors Need to Know

Dear friends,
We trust you and your family have stayed healthy and are enjoying the summer thus far.
The second quarter saw major stock market indices maintain an almost uniformly upward trajectory. In our view, this expansion has been driven by three primary factors:
1. A recovery in business earnings
2. Accommodative fiscal policy
3. Expansionary monetary policy at the Federal Reserve
Earnings of large American companies have indeed rebounded over the past few months, almost retracing the steep 35% decline in earnings seen during 2020. Consumer and business spending have made up for lost time during the gradual reopening of the US economy. The future path of earnings though, is far from certain, as are the long term prospects for several companies, and even entire industries. This has not stopped investors from pouring money into the stock market at a record-shattering pace. According to data compiled by Bank of America, 2021 US equity inflows project to annualize at $1.178 trillion which would blow away not just any previous year, but the cumulative equity flows for the past 20 years ($777 billion). Other measures of equity market frothiness are also flashing major warning signs, including the amount of margin debt outstanding, which is at all time highs. These heady levels have not gone unnoticed by corporate issuers. IPO offerings are at record levels, with companies rushing to sell shares into a market eager to buy.
When viewed in historical context, current equity levels stand out as outliers on both valuation and technical levels. So it’s clear earnings and market dynamics alone are not telling the complete story.
The second major driver of equity froth is the enormous amount of government stimulus that’s been pumped into the system. US fiscal policy remains exceptionally accommodative as legislators rightfully express continued concern about the impact the pandemic has had on both consumer and business finances. Our expectation is that federal support for unemployment benefits and other support for consumers and businesses will continue at elevated levels, as will aid to local governments. Though not their primary purpose, these actions have in effect buoyed the equity markets, by putting a floor under household income and by extension business revenues in several sectors.
Monetary policy is the third pillar that has supported stock valuations. The Federal Reserve has made large dollar amounts available to the banking system. M1, the basic measure of money supply was expanded to include money market accounts in May 2020. This led to a vertical rise in the graph below, which we can ignore. However, M1’s growth has accelerated as the Fed has bought treasuries and other debt instruments with dollars, expanding its balance sheet and injecting those dollars into the system. You can see this in the slope of the graph below, beginning in March 2020 and continuing till today.

The Fed balance sheet now stands at over $8 Trillion, twice what it was less than 18 months ago. That means the Fed has injected $4 Trillion dollars into the US monetary system, a multiple of that when we consider the velocity with which money changes hands. Many of those dollars have found their way to the stock market as noted above.

The Federal Reserve has also continued to keep long-term interest rates at historic lows. Though unemployment rates have come down sharply from a record high, the Fed remains focused on improving the employment picture. We believe the Fed has recognized this pandemic is restructuring the US labor force in more fundamental ways, which has led it to be more cautious around raising rates. The civilian labor force participation rate has been on a downward trend as the baby boom generation ages out of the workforce, with many older workers retiring earlier than planned.

As workplaces have reopened, several million American workers have thus far remained out of the workforce, neither returning to old jobs, nor looking for new work. This is a secular shift in the US labor market, and will affect long term productivity and growth rates. These changes, along with other shifts, will impact other facets of the economy, including productivity. That said, there are some indications that the Fed is considering increasing rates in 2022, which is a year sooner than it had previously communicated.
The Fed has a dual mandate, to support full employment and control inflation. Housing costs are the largest component of the consumer price indices and the single largest expense for households. Single family home prices have been bolstered by low interest rates and an increased interest in such properties from financial investors. This has moved housing costs upwards for households buying homes over the past year. We have seen anecdotal reports of rents rising sharply in many parts of the country, particularly smaller cities that have seen an influx of telecommuters from coastal metropolitan areas. These anecdotal observations are borne out in the data, the housing price index trend line has recovered and become steeper in the past few months. Food prices have also begun to trend upwards. The primary gauge of inflation in the US is the consumer price index, which measures costs for a basket of goods and services used by an average US household. The CPI recorded its highest reading in 30 years earlier this summer, suggesting prices in May and June 2021 rose at an annualized 5% rate. If similar data continue to come in, we should expect the Fed will begin to raise rates sooner than anticipated.

If inflation were to rise suddenly, we would expect the bond market to react quickly. Long term rates would rise, and bond prices would move sharply lower. Bond investors have been remarkably sanguine in this era of historically low yields, lulled into complacency by very low levels of inflation. We have not seen long term rates over 5% since 2006, and inflation has remained below 5% for at least as long. If inflation expectations were to rise, bondholders would quickly face the prospect of negative real returns. In such a scenario, borrowing costs for businesses and governments would rise sharply, negatively impacting earnings. Our view is that the stock market will anticipate these events and sell off if it becomes clear that inflation is materially higher than it has been in the past 2 decades. Given the heady heights the stock market has attained, the sell off would be remarkable.
In our view, the Fed has been too lax in allowing such a bubble in risk assets to develop. By keeping rates at extraordinary low levels for over 15 years, and engaging in outsized asset purchases, the Fed has again allowed a dangerous situation to develop in asset markets, which could have an impact on the real economy. That said, the blame cannot be placed on the Fed’s shoulders alone. The US is an outlier among industrialized nations in having a very weak set of social service programs. Even these are not uniformly implemented, with many states further undercutting an already weak safety net. Over decades, several administrations and Congress have allowed these programs to atrophy. Instead of funding social programs, they have leaned on the Federal Reserve to maintain very loose policy. To put us back on a sound, sustainable footing, we will need to see the balance between fiscal and monetary policy restored in the US.
Looking ahead, we continue to advocate for cautious allocations in investment portfolios, with lower risk allocations than investors would take on in ordinary circumstances. There are strong indications that we are towards the end of a bull market for both equities and bonds. We view speculative growth/momentum stocks to be most at risk on the equity side and long duration and high yield bonds most at risk on the fixed income side. We continue to prefer value stocks over growth (despite value being out of favor in the current market) and view precious metals, commodities and inflation protected bonds as good diversifiers and hedges against potential inflation risk.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

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