Market wobbles, but remains unaware of the bigger problems

Blain’s Morning Porridge Feb 22nd: Market wobbles, but remains unaware of the bigger problems

“All the secrets of the world worth knowing are hiding in plain sight…”

This morning: Markets wobbled yesterday on the current litany of fear: interest rates, inflation and Ukraine. The bigger issues are just how unsustainable current equity valuations remain, and where to invest in range-bound markets.

Did we have a wake and smell the coffee moment yesterday as US markets slid?

Bond yields rose. The stock market fell. Higher rates, fears of unsustainable corporate earnings and a weakening macro-economic outlook, inflation, the rhetoric around the war in Ukraine, geopolitical power blocks changing, all weighed heavy on markets. Yet, a 2% slide on any day is no longer a crash or even that unusual. Commentators say it’s range trading in uncertain markets.

I am told by smarter stock pickers than myself that equities are the place to be. Buy fundamentals for value, buy tech stocks because they are cheap. Buy stocks because they will outperform bonds. I wonder if they are guessing…

Blah, blah, blah… heard it all before. Yawn. Lots of folk think yesterday was just another typical day in markets. Bonds go up. Bonds go down. Stocks rise. Stocks fall. The markets are sort of up on the year… so they must be going higher. Yesterday’s fall is a buying opportunity. What’s to worry about. Employment is high across the west. The Covid reopening continues. Recession threats are receding. Inflation is falling. And even cryptocurrency BS articles are getting printed again…

Should we be concerned?

Always. Always be wondering and planning for what happens next. (That’s very different from knowing what comes next: one of my key market mantras is “no point worrying today about stuff you know you have to worry about tomorrow..” Think about it.) It’s the no-see-ums that hurt most.

The current problem with markets is the biggest no-see-um, an imbalance that’s so clearly hidden in plain sight – might be coming due. We are choosing not to see it.

Here is the problem:

• Since 2010 the US economy has expanded from $15 trillion GDP to $25 trillion, up:
  • +40%
• The stock market (S&P 500) is up:             
  • +270% 

Basically, the stock market’s value has expanded nearly 7 times as fast as the underlying economy… but… traders still think it’s going higher. How sustainable is that?

Explain to me why current stock market valuations make any sense?

Part of the problem with markets is experience. Traders are rather Pavlovian. Give them enough biscuits and you can train them to perform and think in specific ways. That’s essentially what’s happened over the last 14 years since the beginning of monetary experimentation, artificially low interest rates and distortion. It trained the market to expect an easy ride. Risk prices and corporate financial decisions have been utterly distorted by setting the risk-free rate – government bonds – too low.

I’ve lost count of how many times I’ve warned about distortion in the Morning Porridge. I’ve said it so many times folks have stopped listening. I’m dismissed as the mad old man who thinks the sky is going to fall on our heads… Nope. I just think we have not yet experienced the inevitable consequences of fecking around with the fundamentals of money the last 14 years or so. (And it won’t be the first or last time Stocks demonstrate the laws of mean reversion!)

Markets are unaware of how the plates are shifting beneath them…. Many market participants were juniors back when the last crash occurred. More were still at school. They have many lessons to learn.

Yesterday will not go down in financial history for any profound realisations about the nature of markets, a startling moment of clarity, or blindingly obvious pivot point. It was just another 21^st of February. Any normal day. Normal market news flow; like US retailers expressing doubts about the outlook, warning about the risks of consumption tailing off, as the market continued to bet on “Higher for Longer” interest rates, while talking heads from planet analyst pontificated about how sticky higher inflation is proving to be. Maybe folk will remember Biden and Putin both framing the Ukraine war from their own perspectives. There was just enough negativity to tip the scales to sell.

You can see the tumble-weed blowing down the high street….

Who knows about today..? Maybe someone will say something positive about car sales, or how strong employment has increased government revenues thus it can cut borrowing, and the market will take that as another buy signal. Buy!

As usual.. the focus on the immediate, the short-term, the obvious. We need more than a wake up a smell the coffee moment in markets.. But it’s not today’s coffee we should be worried about – it’s what’s been in the coffee have we been drinking since 2008… And what will the consequences be?

We might not realise it, but we are now in a period of massive market transition following the 14 years of easy money since the 2008 Global Financial Crisis. That effectively ended in 2022 as inflation allowed Central Banks to start “normalising rates”. Although rates have risen, central banks have hardly really tightened at all – interest rates still remain in negative “real” territory – less than inflation. That makes absolutely zero sense from a bond investment perspective. Yet yield curves are negative – inferring a recession because short-term rates are higher than long-term rates because we think rates trend back to normal.

If you are buying longer dated bonds at negative real yields in the expectation rates are going to fall – then you are contradicting yourself: you are buying a loss today, and to get a positive return, rates need to rise, meaning further losses. Dah..da!

Problem is the market seems to be assuming interest rates since 2010 were normal and were going back to 3% and 2% inflation. These were not normal. They were an aberration, an offence against the gods of markets! Normal rates are found in normal business cycles – the ones Central Banks always end with a crash landing as they get rates wrong. Normalised interest rates which balance the price of money with growth, and incentivise real growth by focusing investment into the real economy (building real stuff from factories to ships) – are probably 5-6% in good times. They are positive real rates. 3% inflation and 3% charge for money = 6% interest rate.

Artificially low interest rates focuses investment purely into financial assets – that’s the proof we saw demonstrated these last 12 years. Its proved better to buy stocks than bonds to garner any return, and it’s better to buy-back stocks to boost the stock price than risk a new product or factory!

The result is today we still have a massively distorted and overvalued stock market. It will correct. It might happen slowly. It might happen by flatlining a few years with persistent inflation correcting its real value. Or might just happen fast if the market realises the coffee it’s been drinking is lacked with CBD!

Where to invest? As said before I keep gold. Bond yields have to rise to a positive real rate vs inflation, but with bonds you do get your principal and interest back. Or you can look at Alternatives; investing in the real economy to receive income streams based on real business… that’s also looking preferable. And that’s why my day job is spent – in Alternatives…

In short… I don’t trust this market.. I can feel something shifting underfoot…

Five things to take your mind off my havering…

FT        US Stocks record worst day in two months on rate rise worries

FT        Vanguard chief defends decision to pull asset manager out of climate alliance

WSJ     A trader Says Code Allowed Him To Withdraw Millions From a Crypto Exchange. Prosecuters Says He Crossed a Line

BBerg  Goldman Says Hedge Funds Primed to Gain From Stock Picking Boost

Spectator        Meghan Markle upset at her depiction on South Park

Out of time and back to the day job

Bill Blain

Strategist – Shard Capital