On Monday, Reuters ran an extremely rudimentary piece carrying what I can only describe as a deliberately inflammatory headline.
“Federal Reserve’s $3 trillion virus rescue inflates market bubbles”, the title proclaims, as if to suggest there’s a scoop involved.
For anyone with even a passing interest in markets, the article isn’t worth reading, which makes one wonder why it was written in the first place. There are five charts, one showing the juxtaposition between quarterly S&P performance and annualized GDP growth (meaningless, because equities pull forward expected future outcomes), a second showing the forward multiple on the S&P (which is obviously elevated because the speed of the rebound in equities created a huge disconnect with earnings forecasts, which had to be rapidly revised lower), a third showing IPOs, a fourth illustrating the blistering pace of corporate bond issuance (that one is key, and I’ve discussed it exhaustively here), and a fifth that just shows investment grade and high yield spreads.
Again, none of that is news to anyone who’s been paying attention, and neither is it news that Fed stimulus inflates bubbles in equities and corporate credit.
So, why bring it up if it’s just a generic “for mass consumption” article? Well, I’ll tell you.
It’s important to note that the equity rally in the US is defensive in nature. It’s not totally clear whether all market participants realize they’re adopting a defensive stance when they chase mega-cap tech higher (they may actually be thinking the opposite), but I suppose it doesn’t matter. Tech is synonymous with utilities now (as well as with God only knows how many other factors that inform smart beta product construction), so in addition to its post-financial crisis role as the secular growth expression par excellence, the space is a bond proxy and also looks poised to capitalize on expected trends in human behavior in a post-pandemic reality.
The point is that getting overweight tech stocks is not an aggressive approach, despite their elevated multiples. Rather, it’s a de facto defensive position. I’ve spent quite a bit of time pounding the proverbial table on this lately, most notably in “No, Stocks Aren’t Pricing In A ‘V-Shaped’ Recovery” and “Zeitgeist Unchanged“.
Pieces like that published by Reuters on Monday ignore this nuance. There’s a short section in their article called “stock market bonanza”, which correctly charges that the Fed’s “credit support for large swaths of corporate America [has] driven yield-hungry investors back to the equity market”. But it fails to mention the fact that the rally in stocks is decidedly skewed towards equities expressions that suggest investors are highly skeptical of a robust, “V-shaped” recovery.
“Since there’s no common definition for ‘V-shaped’, we’re going to support the home team and use [our] above-consensus economic forecasts”, Morgan Stanley’s Andrew Sheets wrote Sunday, noting that the bank expects “a modest second wave of infections this winter, widespread availability of a vaccine in the US by mid-2021, and continued support from fiscal and monetary policy”. On top of that, the bank’s economists are looking for “pent-up savings” to boost consumer spending in 2021, and they do not expect the global economy to “suffer a lasting, deflationary shock”.
And yet, as Sheets goes on to write, “markets have other ideas”.
If anyone had faith in the Fed’s capacity to rescue the economy, you’d expect the “frenzy” (as Reuters calls it) in equities to reflect that. There would be “demand for smaller, more cyclical businesses, which have more gearing to economic activity”, Morgan Stanley says, adding that it “should reduce the discount for lower-quality companies and credits, as a rising tide lifts more boats”.
Instead, Sheets goes on to note, “relative valuations for global small caps versus large caps are well below average, and low-quality stocks have almost never been cheaper to high-quality ones”. Meanwhile, in credit, he flags an elevated basis between BBB and A and B and BB.
All of that, he reminds you, “suggests the market is deeply suspicious of growth returning to normal”.
The top pane in the figure (below) is indicative of the growing disconnect between big- /mega-cap tech and the broader market, although it’s not a “clean” read, because the tech titans make up ~22% of the S&P’s market cap.
The bottom pane in the figure shows that the Nasdaq “VIX” recently dove to its lowest levels relative to the “regular” VIX ever. (The plunge in February 2018 was attributable to the implosion of the VIX ETP complex, which makes it anomalous — stripping out that episode, the two low points marked “COVID” on the chart have no precedent.)
Reuters quotes Andrew Brenner, head of international fixed income at NatAlliance as follows:
COVID-19 is now inversely related to the markets. The worse that COVID-19 gets, the better the markets do because the Fed will bring in stimulus. That is what has been driving markets.
That is sort of true. But, again, it misses critical nuance.
COVID-19 infection totals are positively correlated to the outperformance of the stocks expected to benefit from a slow-growth world, where consumer habits (and human interactions in general), are forever altered. The figure (below) illustrates this rather poignantly.
This is nothing new. In fact, it’s been a fixture of the post-financial crisis world.
There’s a lot of truth in the quote Reuters uses from Mr. Brenner, but the “bad news is good news” dynamic he’s describing manifests in a particular way that suggests market participants do believe in the power of liquidity (i.e., the printing press) when it comes to juicing financial assets, but not necessarily the real economy.
“Now that Apple, Microsoft, and Amazon all have market capitalizations of $1.6 trillion or more, the three can drive the majority of the index move, as they did last week”, JonesTrading’s Mike O’Rourke wrote Sunday evening.
“While the narrowing leadership appears to be hitting extremes, it has been an ongoing trend for years”, O’Rourke went on to say, noting that “the decade-long environment of exceptionally easy monetary policy, accompanied by the indexing explosion, has been a boon to large-cap growth names”.
And that becomes self-fulfilling. Just as wealth concentration in society tends to undermine democracy, so too does the narrowing of the equity market perpetuate itself, creating an inegalitarian spiral.
None of the above is to pick on Reuters, whose article will invariably get the job done, where that means generating traffic. But you should be aware that using the phrase “stock market bonanza” to describe a situation where anything and everything that would benefit in a strong recovery is trading historically cheap to the “stuff” which will perform in a slow-growth world, is misleading at best.
All of that said, if you’re simply interested in how benchmarks are likely to perform in an environment of abundant top-down liquidity provision, this is a pretty simple calculus.