US Strategy Weekly: History in the Making

Stock prices moved higher this week on the back of good earnings results for the third quarter. However, the 10-year bond yield (TNX – 16.35) and the WTI crude oil future (CLc1 – $83.00) also moved up which implies that higher interest rates and higher inflation are in our future. Most companies reporting third quarter earnings indicated that rising raw material and transportation costs are becoming a margin problem, but in nearly all cases, corporate leaders state they plan to pass these costs on to consumers via higher prices. As we have been suggesting, inflation is not a temporary phenomenon, but is becoming engrained in the system. In the months ahead the risk of margin pressure and/or higher consumer prices increases. The former will hurt earnings, but the latter could negatively impact consumption and top line growth. In sum, earnings risks are compounding.

We believe the fourth quarter of 2021 will be a time of shifting trends, but right now little has changed. Monetary policy remains extremely accommodative, and the Fed continues to buy $120 billion of securities per month flooding the banking system with liquidity. But this week Federal Reserve Governor Christopher Waller, in a speech to Stanford Institute for Economic Policy Research, stated that tapering of asset purchases should commence following the next Federal Open Market Committee meeting set for November 2-3. This implies a change is on the horizon, but remember, monetary policy will remain stimulative, just slightly less so. Putting recent Fed actions into perspective, the central bank has purchased $4.3 trillion assets since the end of 2019, a number that represents 19% of nominal GDP. Fiscal stimulus has added $6 trillion of liquidity to the economy and together this stimulus is the equivalent of more than 45% of GDP, a historic level! However, this is unlikely to continue. Easy monetary policy will slowly shift and could end by mid-2022. Fiscal stimulus is unknown. To a substantial extent, the stimulus package working its way through Congress is not apt to have a major impact on the economy. Most of the proposed spending in the bill will go to federal agencies and programs — not directly to households. Government bureaucracy tends to mute the impact of money spent by Congress. Again, stimulus support will be waning in 2022.

But this is not likely to be true for inflation. Even if supply chain issues get resolved quickly, the rising price of energy will keep inflation elevated in 2022. With WTI futures at $83 a barrel, crude oil prices are up 130% year-over-year. These prices will be trickling down into producer and consumer price indices over the next three to six months. Auto sales have been weak recently due to a shortage of semiconductors; however, auto makers indicate that once production resumes, auto prices will move significantly higher. Raw material costs are also raising the price of new homes, remodeling, and home furnishings. The two segments of the economy that have not experienced big price increases have been homeowners’ equivalent rent and healthcare. But last month’s CPI data showed that housing costs are now on the rise and although rent increases tend to lag house prices, they are now beginning to trend higher. Healthcare costs tend to be seasonal and health insurance prices tend to rise in the fourth quarter. For all these reasons, we see inflation remaining higher than expected for the near future.

Keep in mind that inflation is similar to raising taxes on households. Inflation changes and lowers consumption patterns. Historically, inflation tends to lower PE multiples and for this reason higher inflation has made high-growth high-PE sectors like technology more volatile. We expect this will continue. Nonetheless, inflation will benefit the energy sector. Higher interest rates are a positive for the financial sector, particularly banks. To the extent that corporations are able to pass on higher costs to consumers without hurting demand, these stocks should do well. But we favor companies with strong balance sheets, moderate PE multiples and dividend yields in excess of 1.5% in order to insulate portfolios in the fourth quarter.

Not All Records are Good

Recent data on market capitalization, GDP, margin debt and the household’s balance sheet revealed interesting patterns. Market capitalization hit a record 2.23 times nominal GDP in December 2020 and has been hovering around 2.2 times in the first half of 2021. Margin debt reached an all-time high of 3.9% of GDP in June 2021. Both of these ratios imply that the stock market may be running ahead of the economy and that leverage has been an integral part of the market’s advance. See page 4.

The sum of NYSE and NASD margin debt was $903 billion in September, just slightly below the record $911.5 billion seen in August. Margin debt as a percentage of market capitalization was 2.03% in September, slightly below the record 2.07% of March 2013. More importantly, on a year-over-year basis, margin debt has grown 38%, far more than the 20% YOY gain in market capitalization. This disparity in growth can be a long-term risk factor. However, a major warning appears whenever the 2-month rate-of-change in margin debt is 15% or greater and widely exceeds the margin debt in total market capitalization (or the Wilshire 5000). Luckily, this comparison is currently neutral, but we will be monitoring margin debt for signs of excessive speculation. See page 5.

Household net worth increased 7.8% in the first half of 2021 to a record $159.3 trillion. The greatest driver of net worth came from equities (directly and indirectly owned), up 77% in the six-month period. Nonfinancial assets rose 6.5% and financial assets gained 8.3%. For the first time since March 2000, the household’s ownership of equities exceeds its holdings in real estate. Typically, a home is the household’s largest asset, not stocks. Therefore, this significant increase in equity ownership may be a sign of excessive exuberance. See page 6.

Equity ownership as a percentage of total assets was 29.5% in June and as a percentage of financial assets equities was 41.5%. Both of these percentages now exceed the previous records made in March 2000 at that major market peak. The counterbalance to equities was the record low in debt securities, now at 3% of financial assets. This is a result of historically low interest rates, the Fed’s dovish monetary policy, and it helps to explain how monetary policy can inflate asset prices and runs the risk of generating a stock market bubble.

We do not believe the equity market is a bubble, but valuations are high and equity ownership is at record levels; therefore, it is wise to be on the alert for signs of extreme optimism or excessive leverage. To date, these are not apparent. However, as Mark Twain famously wrote “history does not repeat itself, but it often rhymes.” The current cycle includes the introduction of meme stocks, bitcoin, and other digital currencies. Therefore, we should be aware that the signs of speculation used to identify equity tops in previous cycles may not work as well this time.

Technical Update Market gains have lifted all the popular indices above their key moving averages this week, including the Russell 2000 index, which continues to lag but is now above the critical 200-day moving average. However, volume on rally days has been well below average and this makes the advance suspicious. The 10-day average of daily new lows increased to more than 100 per day this week, erasing the looming negative seen a week ago. The 25-day up/down volume oscillator is at 1.82, its highest and best level since June, but it still remains in neutral territory and has not confirmed any new high since February. Keep in mind that the Russell 2000 index made its all-time high back on March 15, 2021. Overall, broad-based upward momentum may have peaked in the first quarter of 2021.  

Gail Dudack

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