Volatility is our companion again.
Value stocks are outperforming, and the Nasdaq is plunging one day and reversing the next. The bond market is making lower lows and lower highs. While it seems to be plumbing for a bottom, one isn't evident yet.
Investors are engaging in an old mistake: they are looking to history for similar patterns and experience by which the current market and economic environment can be understood and from which reliable projections can be made.
But while market and economic patterns generally tend to repeat, it sometimes is no longer reasonable to rely on those expectations when inputs change dramatically. To wit: the U.S. economy was supported by about $6.3 trillion in "stimulus" in 2020, which includes about $3.1 trillion in deficit spending and a $3.2 trillion increase in the size of the Fed's balance sheet.
Congress has already authorized an additional $1.9 trillion in economic support so far in 2021. Together with the $900 billion authorized in December of last year, a total of $2.8 trillion has now been authorized in the past 90 days. That's 13% of the entire U.S. gross domestic product in a single quarter.
"It's different this time"
Old Wall Street wags know that the words "It's different this time" are among the scariest an investor can hear.
At critical moments throughout history that phrase has been one of the best contrarian indicators around.
But I think too many inputs are dramatically different in the first quarter of 2021 to expect that outcomes will follow any historical script.
We have no idea of the ultimate consequences of such enormous government spending, and we may not for several years.
Fed Chairman Powell announced this week that the economy is recovering. GDP growth estimates are going above 6%. A surge of inflation is expected, but according to the Fed and others it will be temporary. We will return to full employment in 2022. The Fed is prepared to let things run hot for a while to make sure the economy really heals this time. Moreover, investors needn't worry because everything will be hunky-dory.
I think a few things are going on:
- Upon reflection, markets don't appear to be buying Jay Powell's sanguine message.
- Two weeks before the quarter's end is a quiet period for most companies. With the stimulus bill signed, there are few other headlines to get investors excited.
- Higher interest rates are spooky reminders of how the Fed can lose control of an economy. This begets worry.
- I don't buy the higher yield argument taking the wind out of tech stocks. Yes, it changes the rate at which future cash flows are discounted and makes prices appear higher on this fundamental measure. But following a long period of massive outperformance, tech stocks have been untethered from fundamentals for years. Netflix, Tesla, and Peloton are hype/cool concept companies with investor bases that don't worry about "no stinkin' fundamentals!" But with the yield on the 10-year Treasury note up 1%, fundamentals are now suddenly going to matter?
I don't buy it.
We're clearly witnessing some profit-taking and a broadening of the market rally. These reactions may, in fact, be long overdue.
But anybody who believes it makes sense to go to cash in the face of $2.8 trillion in new stimulus, a dovish Treasury Secretary and an ultra-accommodative Fed understands neither mathematics nor physics.
Finding a new trading range
Watch the bank stocks. They get it. An increase in longer-term interest rates is healthy for their businesses and reflective of economic firming over the near term.
Yes, valuations are high, but the potential for up 10% nominal GDP growth and rapidly rising earnings estimates may justify the lofty prices.
Finally, it's worth noting that the first quarter and pre-Tax Day season are historically periods that expect corrections and volatility.
Keeping a steady hand during worrisome times is how most disciplined managers and investors make their money. Nobody minds upside volatility, and everyone hates the downside variety — except, of course, those of us who are always looking for better prices to buy.
This feels like the market is trying to establish a new trading range. It needs to test up and down and go sideways for a bit.
Treasuries need to find their range, too. Maybe 1.75% will be the high end or maybe not. The market's pricing mechanism is always working, always adjusting for new data, news and expectations. It's uncomfortable at times, but normal.
Investors need to focus on the longer term, watch the new dollars flooding in, and don't fight the Fed.
—Michael K. Farr is a CNBC contributor and president and CEO of Farr, Miller and Washington.
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