The broad stock market had another year of gains well above average. It has rolled through the pandemic lockdown in the spring with a quick V-shaped bottom and continued to rise throughout the turmoil of the election cycle and difficult post-election period.
Rarely have we seen a market so determined to persevere in the face of difficulties. The prospects of easy money and relief from vaccines to whip the Wuhan virus seems to dominate positive thinking. Market action has been truly impressive.
It may well be justified. Many feel pent-up demand will emerge. People are tired of being imprisoned by lockdowns and as the threat wanes, people may well come out in droves and spend their heads off.
The Federal Reserve has promised to keep interest rates low and the new Treasury Secretary Janet Yellen (a former Fed Chair) has told Congress to “go big” on the stimulus. The Fed itself continues to pump liquidity into the system through Quantitative Easing. We are getting a blast from both barrels of monetary and fiscal stimulus.
A large stimulus was passed at the end of the Trump administration and he had called for substantially more.
Biden is now talking about raising the benefit from the $900 billion passed under Trump but not yet spent with another round of checks perhaps as large as $1.9 trillion.
That would be stimulative in the short run, but it is contradicted by increased regulations and higher taxes. Neither would the drift toward socialism prove helpful.
Meanwhile, the national debt approaches $27 trillion. No one in either party seems to care. Excessive debt is not a problem until it is.
While the ability of the market to shrug off difficulties is impressive, we have reached a curious stage. It will be hard to know what is real pent-up demand and what is unsustainable spending based on debt, deficits, and currency debasement.
The market is now expensive, if not overvalued, by most traditional measures. As always, there is a robust debate about what measures to use but the three best market cap to GDP (Buffet’s favorite), price to sales ratio, and Tobin’s Q ratio (market value divided by replacement cost) are at all-time highs. Other measures show the market to be expensive, but not necessarily excessively so.
Moreover, there are concerning signs of the froth and excessive speculation that have appeared in previous market cycles.
Yet despite this, market internals remain healthy and point to higher market prices ahead. An expensive market can get more expensive.
Jason Goepfert, editor of Sentiment Trader succinctly sums up the conundrum: “Signs of excessively optimistic sentiment abound, but internally markets have been very healthy so far.”
What is sentiment and why should we care? To understand this concept, we have to back up a moment and discuss “the theory of contrary opinion.” Briefly put, the idea is that people establish a viewpoint, then they act on those beliefs and their financial action works its way into the price structure of the market.
For example, when everyone was chasing Beanie Babies, they were hard to find and very expensive.
Years later, no one wants them, and the price is much lower if you can find a buyer at all.
But it is still the same toy, right? Why such a difference in value? As the Austrian Economists teach, value is subjective.
So, if everyone is thinking easy money will do the job and the pandemic will go away, while that may be wonderful, it could already be in the current price structure.
Thus, markets get into trouble, become overvalued and frothy when just about everyone is overconfident. Markets tend to bottom and be a good value on pessimism. To execute the theory, the investor is supposed to sell when everyone is delirious and buy when everyone is scared witless. Or as Warren Buffet put it, “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”.
A corollary to this line of thought is this: when everyone is thinking the same thing, no one is really thinking. Markets at extremes can reflect the irrational herd instinct in human beings. Markets are rational calculating mechanisms, most of the time. People are rational, most of the time. But people do have periods of irrationality and guess what – markets are made up of people.
People will buy things, simply because they are going up and they expect to take the financial ride to riches.
If you have been through a few market cycles, you know the psychological pendulum swings, both ways. Markets cycle from overvaluation to undervaluation. The problem is that our tools for knowing when markets are about to shift are lacking in precision.
What has some seasoned investors bothered are the signs of excessive enthusiasm are starting to appear again, much as they did in the tech bubble of 1999 and the housing bubble of 2007.
There are two ways to measure sentiment. One is by opinion survey. You ask investors what they think. But people often say one thing and do another. So, it is more important to measure action.
It is in this latter category, action indicators, that has some market mavens concerned. For example, margin debt is at an all-time high. This means people are not just buying stocks with their own money. They are confident enough to borrow money to buy stocks. This is called leverage. Leverage exaggerates movement upward in markets and when markets turn around, leverage can cause exaggerated moves in downward markets. Excessive leverage is a feature of all speculative manias.
Public speculation, especially by small investors, has hit record numbers regarding call options on equities. An option is a way for an investor to control the price movement of a lot of stock with little money. A call is a bullish bet on the market. Lockdowns seem to be causing a huge increase in the number of new brokerage accounts being opened.
Meanwhile corporate insiders, presumably people who know their companies better than the public, are selling at a record clip.
Ultra-small cap companies, sometimes called penny shares, are seeing a lot of excessive action.
We are seeing the growth of more ways to speculate, leveraged Exchange Traded Funds, and SPACS.
What is a SPAC? It is a Special Purpose Acquisition Company. There are now more than 300 of these operated by people ranging from former basketball stars to faded politicians like Paul Ryan. They raise money from investors and then, later, are supposed to acquire new start-up companies of great promise. In short, they are raising money for investments yet to be made. It is literally betting on the come.
The economic historian Edward Chancellor, in his epic Devil Take the Hindmost, writes about the great South Sea Bubble of 1720 and notes, “the most famous of the bubble companies was that for carrying on an undertaking of great advantage but no one to know what it is.” Sounds kind of like today’s SPACs.
Of the 190 bubble companies formed during that mania, only four survived.
We see similar speculative action in new IPOs, or Initial Public Offerings, as we saw during the recent tech mania.
We have seen some truly massive moves in cryptocurrencies.
We could provide more examples, but you get the point. Clearly, the markets are awash with speculative money willing to chase new untested ideas.
We at The Prickly Pear are not your financial advisor. All we can do is report the thoughts of people we respect and our own personal experiences. It might be time for a financial checkup. Things are getting a bit overheated.
We have no better sense of timing than anyone else. The excesses cited might suggest nothing more than just a “pause that refreshes” or it could be more serious. We don’t know. Our concern more is the psychological condition of the market. The lopsided sentiment is usually a warning of at least turbulence ahead. We have seen this movie before.
The problem when markets are priced for perfection is that perfection is rarely delivered.
Neland Nobel recently retired after 45 years in the financial services industry.