Halfway through 2021 is a good time to evaluate the year so far. Market mood was characterized by optimism about growth accompanied by inflationary fears which both slipped back as the half ended. Looking ahead, let’s question the assumptions embedded in today’s market levels and think about the impact on our clients' financial plans.

For stocks, the rapid reopening of the US economy led to the largest gains in the economically sensitive sectors of energy (+45.6%) and financials (+25.7%). Our overweight positions in these areas led to strong gains through May. Technology underperformed the market although it did gain 12%. Commodities also rose by 10.46% with international stocks lagging but rising. The bond market dropped sharply in the first months of the year on inflation fears only to rally back to a small 2.11% gain so far. It is very unusual when all asset classes gain. The massive amount of governmental support has "lifted all [investors’] boats.”

The number one question I am asked is whether this market is overvalued. On the one hand, price performance is strikingly "well behaved:" growing earnings are rewarded by higher stock values. The big question is how much should investors pay for a dollar of earnings? A year ago, a share of the S&P 500 cost $13.30. That price has risen to $21.50 exceeding the historical average price to earnings ratio of $16.70. Based on this, we could argue the market is 29% overvalued. However, it has risen 92% since the pit of the Covid-19 dip and while a selloff to a “fair value” of 3,300 would make headlines as a “crash,” it would leave investors with a total stock return of 63% in the past year.

Looking for good values beneath the averages, financial, healthcare, and energy sectors are still trading below the rest of the S&P 500. International stocks are relatively cheap—trading at $16.50 versus historical averages around $15—and provide an inflation hedge as they would benefit from a weakening dollar, a secondary effect of inflation. While the bond market has been the lowest performing asset class and delivers low yields, it represents a good "value" right now because it boasts a low to negative correlation with the S&P 500; giving us a potent currency to buy dips in other asset classes. This is not a “fixed sum” situation—where our losses directly offset our gains—for two reasons that are mathematically complex but easily stated. As the correlation of assets within a portfolio falls, the sum of the parts goes up. When we combine this with the rebalancing program embedded in your strategy, we can increase dollars in your account when the top line return is low or even negative!

The bigger question behind whether the stock market is overvalued hinges on whether the US economy will keep growing. As I see, there are three growth paths, each beginning with the letter R:  reopening, reflation, and recidivism.

Reopening is the defining theme so far in 2021: increased social and business activity leading to demand for goods and services resulting in growing profits.  This is what is currently priced into the market and the basis for the high P/E ratio. This stock market is "priced for perfection".

 

Recidivism would take us back to the closing economy we saw in 2020 driven by a resurgence of Covid-19 infections and hospitalizations leading to stagnant demand and lower profit growth.

Before we can determine which of these three paths will apply and more importantly, in what order, we need to consider the assumptions embedded in the pricing of the current ‘reopening’ market. The most dangerous risks are those that we do not understand. The past year has taught us, if nothing else, that our understanding of epidemiology and viral dynamics is a work in progress. Remember a year ago, we were still wiping down groceries… 

For investors and society at large there seem three big assumptions behind individual and collective behavior that may prove to be tragically untrue. What would happen if any of these basic assumptions turn out false because of something we have yet to understand?

The End of The Pandemic

The most glaring of these assumptions is that the pandemic is at its late or final stages. I am keeping an eye on the Delta variant particularly in the UK where cases, deaths, and other important metrics are rising despite a widespread and effective vaccination campaign. Could this be coming to the US? Re-entering a lockdown phase is almost unthinkable but if a strain that doesn’t seem impacted by vaccinations arrives in the US (think flu vaccine at 50% effectiveness), the economy could shut down again.

Politics aside, one thing we learned last year was there were surprisingly small differences in the trajectory of economies that shutdown versus the economies that didn’t—by looking at Sweden, which didn’t lock down and similar countries that did. The reason, we found, was that activity correlated more with infection rates than governmental policies. No matter the policy, societies circulated less as the disease impact rose. Therefore, we would expect a rising variant to lead to lower economic growth. In this climate, the recidivism trade would reign supreme as it did in early 2020. 

“Inflation”

The second assumption is that "inflation" is already here, and the price mechanism will rise to adjust for lower supplies of things like computer chips, used cars, and boats. However, I would argue that, in the short run, prices have not risen, in part because current supply shortages are not permanent. There are massive amounts of capital heading to solve this supply side problem. This would explain why commodities, bonds and stocks have, of late, priced in very low levels of price inflation. Looking at the demand side, things are not in higher demand than they were in 2019. I would agree with the Fed's argument that in the short run current "inflation" is transitory. So why has the Fed signaled that we should anticipate higher rates in 2023? 

Tightening the Money Supply

This leads to the third assumption; the Fed is going to tighten money and raise rates soon to stave off inflation. However, I think the same political pressures that led them to signal a rise in 2023, will suppress their ability to reduce the money supply in a meaningful way. The recent massive social unrest, strain on renters, and unemployed service employees contrasts with the top 10% of American households that are now claiming over 50% of the nation's pretax income. Therefore, it's hard to see a politically tenable argument for the Fed to relax the largesse anytime soon. If the Fed is slow to pull back on the stimulus, what does that mean for investors?

Inflation helps debtors and hurts savers. Wealthy individuals living on the “fixed income” provided by investments should certainly worry about how far those fixed dollars will go against higher expenses for energy, shelter, and food.  However, some of their investments might benefit from prices rising.  Specifically, the companies that can raise their prices while keeping expenses under control will be more profitable. Accordingly, shareholders in these companies will enjoy a higher stock price. In this way, inflation may benefit high net-worth individuals with increasing home values and portfolio growth.

Moreover, for most wealthy individuals the largest increase in their expenses is likely to come in the form of taxes. That is why rather than fretting about the price of lumber, toothpaste or even travel costs, it’s better to focus on legislation and what’s happening with tax policies. The prudent steward of their wealth should embark on “what if” planning around increases in state taxes, capital gains and inheritance taxes as these forms of “inflation” are the more prominent threats to wealth right now. 

One thing we have learned in the past year is that change is the only constant. As investors, we can profit if we maintain a long-term perspective; buy things at good prices while thinking through different scenarios and buffer risk to capitalize on opportunity within the context of your financial plan.
 

1. What most are currently calling "inflation” is an incorrect use of the word as inflation implies a change from negative price changes. If prices are stable and rise, the accurate term is "reflation."

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