What the hell is happening?

Analysing and hypothesis testing financial markets during the summer of 2021. Is the market right or wrong?

Market participants like to be in constant communication with each other and get a sense of what is happening in the markets. We like to talk about earnings reports, new opportunities that we may have stumbled upon, the recent rally (or sell-off) and generally the things driving the markets at the time. These days the assessment of most participants is that they don’t understand what is happening.

Something that is driving market activity and sentiment is the tune of the Fed. Investors, thinking linearly, believe that markets will drop precipitously when the Fed reverses (or starts to reverse) the unconventional monetary policy that has been going on for the past decade.

Direct or indirect signs of a policy reversal has a material influence in prices. This is exactly the phenomena that we are experiencing in markets today. Inflation has shown that it wants to go higher and the Fed has brushed this off as a transitory inflationary tailwind, signalling that it will continue with the policy of the past decade until inflation remains above 2% persistently.

You will observe that the pricing mechanism of the financial markets goes especially crazy when there are several large question marks, rather than just a couple. Sometimes complexity is too much for the limited human cognitive apparatus – causing it to default to more simplistic, linear narratives and adopt hypotheses that sometimes don’t make so much sense.

In this letter we will try to formulate a few hypotheses, theories or ideas that the market seems to be adopting, and try to break them down intellectually as a means of making higher quality decisions.

Hypothesis 1, inflation is back so buy quality mega-caps to protect your cash.

Since CPI (Consumer Price Index) inflation spiked last month, parts of the stock market started diverging. 

The Russell 2000 started moving sideways with sudden spikes of selling pressure, while the S&P 500 and the Nasdaq 100 are at all-time highs, driven almost exclusively by the rallies in the stocks of Apple, Google, Amazon, Microsoft and Facebook. 

Will higher inflation going forward enable these companies to make more profit, and hence create more value for their businesses? 

Probably not – but even if inflation could indeed create more value, then why can’t it create more value for other companies besides the five aforementioned? In other words, if inflation expectations were driving investing decisions – investors wouldn’t differentiate between market cap or perceived quality, but between beneficiaries and non-beneficiaries of inflation.

Will buying these companies protect your cash from inflation?

They might protect your cash from inflation as they can raise prices together with inflation, but they won’t protect your cash from future drops in their share prices. 

But why would their share prices drop?

Well, these companies have been the biggest beneficiaries of the Fed’s unconventional monetary policy and the post-covid market rally. Their earnings multiples are at all time highs pricing in very high future growth while their growth rates are slowing down rather than accelerating.

Do you actually think companies like Apple and Facebook are going to stop growing?

No, I don’t expect them to stop growing anytime soon but their current valuations price in a lot of growth from current levels and it is not easy adding tens of billions to the bottom lines of companies just like that. 

For example, Apple’s price to earnings multiple currently sits at 29x, at a time where earnings are benefiting from large tailwinds as consumers went crazy due to Covid. This means you could be buying Apple right now at 40x normalized earnings. Which begs the question, do you expect Apple to double its earnings in the next 3 years? Probably not.

Ironically, Apple’s EPS (Earnings per Share) and hence share price have benefited tremendously from the company’s share repurchase program which is still going on strong. However, the higher the P/E of the company the less the contribution to its Earning per Share per dollar of stock buyback. This should act as another headwind to the company’s EPS growth going forward considering such high valuations.

Result: Buying mega-cap blue chips at any valuation cannot protect your cash from loss.

*Apple has been selected to be used as a generic example of a thought process when analyzing all companies. 

Hypothesis 2, equities will be hurt from the Fed tapering and the increase in interest rates.

It is common knowledge and widely accepted that the stock market has been the greatest beneficiary of the Fed’s policy since the crisis of 2008. Cheap and easy money does wonders for company earnings and the economic environment, while low interest rates push earnings multiples higher.

Will all businesses decrease in value when the Fed finally stops and interest rates go up?

Obviously not. Interest rates are not the single variable that decides the fortunes of every business. If a company is over indebted with floating rate debt and has a very low return on assets then yes even a 1% move in rates could bankrupt them, but that is their problem.

The vast majority of companies are not in that balance sheet situation. Each company is in its own specific growth stage and economic situation. Taper or not, there are investment opportunities out there.

But if other investors believe equities will drop when the Fed tapers, shouldn’t I sell before the taper and buy back at lower prices?

Sure, if you can time that perfectly then you could try and do that. But that would be digressing from the activities of a professional investor who looks to buy and sell as per value considerations rather than trying to trade events like a reversal in Fed policy. 

The important thing to note here is that if you made the right choices as regards the businesses whose shares you bought, value will increase over time and the share price will follow suit.

Result: Well run businesses cannot be hurt from a change in Fed Policy.

Hypothesis 3, protection from higher inflation can be achieved by buying treasuries at a 1% yield.

Since inflation spiked last month, treasury yields fell lower instead of doing the opposite. The interest rates that we see quoted on a given fixed income instrument are before inflation rates. This is called the nominal interest rate.

When adjusting for inflation by subtracting it from the nominal interest rate, you get the real interest rate. Bond investors look out for inflation and inflation expectations because they don’t want to lend their money out to rates that are too low when adjusting for inflation. Considering that inflation spiked, nominal interest rates should have risen to compensate for inflation.

Will investing in U.S. treasuries or other AAA sovereign government bonds protect your money from the monster of inflation?

No, actually it’s the opposite. Bonds have contractul pre-agreed future cash flows. In an inflationary environment those cash flows will be worth much less as inflation devours their purchasing power.

The only case where bonds could protect your cash from inflation would be when the bonds are inflation-protected, and that is very rare. 

Then why are investors buying bonds instead of selling them?

Sometimes investors think too short-term, causing them to make a decision that seems reasonable in the short-term but that will hurt them in the long-term. In this instance they are probably thinking that equities will drop so they can’t go there, and they would rather make 1% than nothing. Sometimes it is as simple as that.

Result: Buying treasuries will not protect you from higher inflation going forward.

Hypothesis 4, investing in an index fund does not carry the risks that investing in individual stocks does.

The past 10 years have given us a bull market in stocks and bonds that seems to be never ending. Investors who were sold on passive investing and allocated capital to funds tracking the S&P 500 index have been proven exceptionally right in their decision to do so.

Since the March 2009 Global Financial Crisis stock market bottom, the S&P 500 has roughly returned 6.5X at the time of writing this letter (July 18th, 2021). Viewed alternatively, the S&P 500 has returned a 2X since the March 2020 Covid stock market bottom. 

Naturally, these returns have kept investors happy and they are hesitant to jump off the passive investing index fund bandwagon. The thing is, you can’t invest with the rearview mirror and you have to assess the drivers that allowed these returns to materialize in the past 10-years.

Some of the major drivers have been:

1) The continued mass adoption of technology products and services mostly sold by the biggest companies in the S&P 500.

2) An expansion of earnings multiples as equities were embraced and the bull market continued. 3) Cheap money helped the economy expand, increasing the bottom lines of companies via organic/inorganic growth investments, share repurchases and a consumer spending boom which set off a self-reinforcing cycle of an ever expanding economy.

Even if investing in the S&P 500 allows you the diversification of investing in 500 different stocks – if the index is benefiting from a handful of things that are transitory, then it is like investing in one stock, because when the aforementioned drivers turn south they will turn south together. 

Can continued quantitative easing (money printing) and near-zero interest rates by the Fed further expand earnings multiples and add billions of dollars of value to companies?

Earnings multiples have a ceiling and at this point they are running at all time highs. Actually, after all these years of multiple expansion one should expect a contraction of earnings multiples and not an expansion.

Isn’t investing in the index a long-term bet on the U.S economy and hence a bet that is impossible to fail?

If we consider the prevalence of the U.S economy as a given (and that is a big if), then price still matters. You can’t buy companies at any price and still expect to get a great result. Companies in the S&P 500 have sales, profits and returns on investment. They are companies too, just like individual stocks.

Don’t you agree investing in individual stocks is much riskier and doesn’t make sense?

Well, most billionaires in the world gained their billionaire status by one single company. All business comes with risks as well as rewards (that includes index investing). The best advice I could give on this is that you should always know what you are doing and what you are betting on, whether it be an individual stock or 500 stocks.

My fear is that passive and index investing has been softly marketed as a defense against ignorance, risk and volatility. Wall Street tends to go through these cycles of mass marketing and adoption of an investment product, touting it as the solution to all of an investor’s problems. But then the adoption of the product is taken to excess, and all the reasons it made sense before no longer exist. The portfolio insurance debacle of the 1980s is one example.

Result: Investing in an index fund offers you diversification from a more concentrated portfolio, but does not shield you from the risks of the overall market.

Financial markets can be both rational and irrational. Following the herd unintelligently without having your own thesis or understanding of what is happening will hurt you financially. 

Markets can adopt a thesis and unadopt it just like that. Make sure you know what you are betting on and don’t just follow the market blindly.

The individual has always had to struggle to keep from being overwhelmed by the tribe. If you try it, you will be lonely often, and sometimes frightened. But no price is too high to pay for the privilege of owning yourself.

-Friedrich Nietzsche

A good idea becomes fatally dangerous when taken to extremes.

-Unknown