One of These Things is Not Like the Others

Inflation is dominating headlines around the world...except in Japan. While most OECD countries are experiencing the biggest surge in inflation in decades, Japan continues to struggle with deflation. In the U.S. the Consumer Price Index ("CPI") gained 6.2% y-o-y in Oct, the highest increase in over 30 years. The U.S., U.K. and other major OECD economies have now averaged a 2.5% y-o-y increase in CPI over the past twelve months; Japan just -0.5%.

                                  Source: OECD.Stat, Mantabye

                                   

Inflation in moderation is good for the economy, but too much or too little it hurts economic growth. Japan has been fighting deflation ever since its economic bubble burst in the 1990s. Over that time Japan has attacked the problem with innovative policies, including "using negative interest rates to encourage spending and injecting money into the economy through large-scale asset purchases, a policy known as quantitative easing." But nothing has really worked. Economists believe a combination of self-fulfilling expectations of lower prices, Japan’s aging population, globalization, and technology have worked to worked to keep demand and costs down. It's part of the secular stagnation thesis, popular among prominent economists. The big worry, even a few quarters ago, was that the U.S. and Europe and would also struggle with the same forces. And they may yet do so, but for right now one of these things is not like the others. 

Stock Market Bubble? Yes!! No!! Who Knows?!

January saw a wild ride in stocks, particularly junk stocks. Widescale vaccine rollouts, permanently dovish monetary policy, massive stimulus with direct cash payments and the possibility of more government aid to come...are pushing equities to record highs. But how much higher can markets go?

Some say we are in a massive bubble and face a reckoning...not if, but when. Others are more bullish, rationalizing reasons why markets fundamentally will go up (a slight tangent here, but most sell-side research are typically self-servingly bullish---at a brokerage house you're never penalized for being bullish and wrong, just for being bearish and wrong. You can't really blame them...."research" is really just marketing...part of ibanks' expenses to get trading commissions; and over two-thirds of the time, the market goes up...so it's a numbers game).

Which brings us to Warren Buffett's "favorite" valuation metric: the market cap/ GDP ratio. A good description is available at the Current Market Valuation blog. The intuition is that stock market growth reflects underlying economic growth. Over the long term it should be roughly 1:1. So, below 100%  stocks are undervalued; above 100% they are overvalued. Currently the ratio stands at 288% ($48.7 T/ $21.7 T) or nearly 3 standard deviations from the historical average...something you'd expect to see once every 300 years. The U.S. is only 244 years old (and GDP data has only been collected for ~100 of those)...so hmm, something to think about. 

Mind you, it's NOT a market timing tool; as they say, "the market can stay irrational longer than you can stay solvent." Another big deficiency of this indicator is that it does not take into account the level of interest rates. Rates influence borrowing and profit margins of companies (and thus their valuations) as well as the the attractiveness of bonds relative to stocks---two competing investable asset classes.

The chart below shows GDP and stock market growth trends. Taken by themselves...clearly the market seems to be running ahead of itself, by a lot.

Now, compare the ratio with interest rate trends (click to enlarge chart below)...historically, when rates are low, the Buffet Indicator is high and vice versa. So as long the Fed keeps liquidity flowing, stocks will run hot. That's the tsunami that overwhelms everything else. And we've written about the empirical evidence of the Fed put. While proping up the stock market is not a part of the Fed's mandate...the Fed pays very close attention to it...believing a drop in stock value creates a negative "wealth effect" that feeds into a cycle of negative consumer sentiment and lower economic demand. And market participants know it and hold the Fed hostage to it.

But if there is one thing that does scare the market it's the spectare of uncontrolled inflation forcing the Fed's hand. Price stability is a Fed mandate. And if the Fed has to choose between controlling inflation and propping the stock maket, its going to choose the former... But inflation is not really a problem for the Fed right now...on the contrary deflation is probably the bigger worry. In fact, a little inflation is good for "greasing the wheels" of commerce. And depsite providing oceans of liquidity over the past decade, the Fed has not been successful at bringing inflation up to the 2% per year that's considered "good." 

If inflation expectations remain low then investors are being rational in choosing stocks over bonds. Currently the benchmark 10-year Treasury bond is yielding 1.2%. The widely followed Shiller CAPE ratio for stocks currently stands at 35.8; in another words, stocks are yielding 2.8% (1/ 35.8) or 2.3x bonds. Sure stocks are riskier, but at such low rates bonds are risky too. So the "equity premium" or spread over bond yields is compressed and investors favor stocks. 

Why has inflation stayed so low despite record low unemployment (at least pre-Covid), massive tax cuts and very accomodate monetary policies? No one really knows...

The net effect is all this probably ends very badly at some point...but only when inflation rears its head. Until then, companies will contine to binge on debt and investors will likely continue to reward them with higher valuations and keep the cycle going...so keep buying Growth and Momemtum stocks and Bitcoin.