This is a trade shortened week given the Thanksgiving holiday in the US on Thursday.
This means that most of the heavy hitters are probably away and as such market activities are likely to become muted toward the end of the week.
Undoubtedly, some of the exuberance in markets has been led by expectations around the vaccine and assisted by the appointment of a former Federal reserve chair Janet Yellen as the next Treasury secretary under the incoming Biden administration.
Yesterday, we saw the S&P and Dow Jones industrial index break toward all-time highs. But it has many market commentators and longtime investment strategists wondering how long can the apparent disconnect between the underlying economy and markets persist. Is it a case of the adage of ‘Buy the Rumor, Sell the News’?
Let’s unpack this a little.
Toward the end of 2019 and into 2020, the US and world economy were entering the mature phase of a long-term bull market and economic cycle. Following the financial crisis in 2008, we saw massive stimulus measures enacted to prevent the world from falling into another Great Depression. After a little but of a wobble around 2012 with the Eurozone Debt crisis, we continued to see economies and markets trudge ever higher.
This happened against a backdrop of persistent low interest rates and ever increasing sovereign and corporate indebtedness. Now call me old fashioned, but I believe that debt merely brings forward future consumption/investment and that at some stage this needs to be repaid. Yet, this seems to be a fundamental pretext which has been discarded as investors chase risk assets higher across the board.
How did COVID change the game?
It was against this context that the COVID pandemic hit an already fragile economic backdrop. And then the rules changed! Governments and policy makers around the world were quick to step in and provide stimulus unlike we have seen in generations. It was sorely needed. The pandemic represents a challenge to us unlike any we have seen in our lifetimes. But it has also entrenched a stance toward monetary and fiscal largesse ‘ad infinitum’. Attitudes toward indebtedness and perceptions around the consequences thereof have softened if not disappeared entirely. This has also given rise to the sentiment among retail investors and traders that ‘Stocks only go up’.
This also highlights why the markets took Yellen’s appointment to the Treasury so optimistically. Janet Yellen, during her tenure as Fed Chair, was a notable dove (preferring lower rates and growth to reigning in inflation). It is debatable as to whether it is an accurate assessment, but it is the general market read on Yellen’s leanings.
It also highlights the apparent ‘mergence’ between monetary and fiscal authorities, which has become a hallmark of the COVID response worldwide. While a stalwart in financial markets and no stranger to Capitol Hill, Yellen will need to contend with the Senate in any policy changes proposed and is arguably not as ‘powerful’ in her individual capacity as she was at the Fed. However, for the proponents of ‘Modern Monetary Theory’ or ‘debt monetization’, this is arguably a signal of low for longer and ‘keeping the taps on’.
‘Tis the season:
Post the COVID relief packages, markets rebounded sharply. The apparent correlation in financial assets (potentially as a result of years of monetary stimulus and additional fiscal stimulus this year) remains in play. For the year to date, financial assets are generally up, whether that be equities, bonds or even bitcoin. The dollar is weaker, perhaps hinting that this is ‘all about the dollar’.
It’s also worth noting that over time there appears to be a degree of seasonality in markets which tends to hold up. The ‘Sell in May’ strategy generally gives way to buying in Q4 which typically carries over to January (possibly May). This year appears to be following this trend even amidst COVID, an election year and all the other ‘noise’.
What’s the long game?
The general wisdom suggests that the stimulus provided by lower interest rates eventually wears off. This means that to keep the party going, more stimulus will be needed. In the Northern hemisphere, COVID-19 numbers are rising again, perhaps because of relaxed lockdowns (now being tightened again) and perhaps because winters contribute to a higher prevalence of illness.
The consequence of renewed lockdowns and higher infection rates means that businesses (particularly small businesses) are at renewed risk of failing. The strong will survive. We are not out of this yet. This suggests that the ‘hurrah’ in asset prices appears to be looking through what could still be a tough time ahead.
Perhaps its also because listed markets tend to comprise of mostly larger corporations while Main street appears to be bearing the brunt of this pandemic. Stimulus programs are a broad stroke measure but seem to flow toward the strong while overlooking the weak. This may well exacerbate inequalities and possibly play into an even greater concentration of activity among fewer larger players.
The stimulus, while helping prop up vulnerable businesses, will also likely defer any ‘reset’ in the economy but allowing the middle ground ‘zombie’ firms to continue limping along. I think that the era of high debt will be with us for some time to come.
If bond markets eventually revolt and start to price risk more appropriately, does this imply even more stimulus and support from the Fed, who has already suppressed yields? Do they have more ammo, or will they work in concert with fiscal authorities to try and ‘monetize the debt away’ through inflation (is they have largely indicated)?
Time will tell but for now, don’t let facts interfere with a good story – Stocks are hot. Biden and team will be in by early next year and we will need to see how they can cajole Congress into toeing the line. But if they fail to do so, will this be another case of buy the rumor sell the news?
I will get on my soapbox again and state that my approach to investment is a marathon, not a sprint. One’s investment philosophy will be tested from time to time as it should. We live in a fluid world where old models and paradigms will be tested (as they should). Whether they withstand the test, time will tell.
My psychology remains intact. I believe in diversification, and active risk management. This means that when things are ‘uncomfortable’, make sure you are taking risk you can afford to take. Ensure that positioning (in asset classes or specific stocks) does not get too heavy. I am generally cautious and believe that slow and steady wins the race. For more on my overall thinking and asset allocation, see this piece published a few weeks ago.
Markets are pricing in a lot of good news, so be selective and strategic in your approach. And let’s hope that all the cheers we hear on our way up don’t turn into a lot of ‘Yellen’ should markets take a breather and head back down for a bit.
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