Welcome to a new year. Rarely if ever can so many have wished so fervently for the old one to end. The start of 2021 brings a sense of renewal and possibility.
The problem is that a turn in the calendar doesn’t itself change anything else. The view from my window is the same as it was last year. And certain “2020” issues remain virulent.
As I recorded several times toward the end of last year, the consensus in favor of reflation in the next few years is overwhelming. Ten-year inflation expectations for the US are their closest to exceeding 2% since late 2018 (when the Federal Reserve was still expected to cut back its balance sheet on “auto-pilot”). Intriguingly, 5-year 5-year expectations, covering expected inflation between 2025 and 2030, are slightly lower, suggesting a belief in relatively imminent inflation that subsequently comes under control.
There is a growing argument over whether we are living through a repeat of the dot-com bubble of 1999 and 2000. Purely subjectively, I don’t think we’re there yet. That bubble happened before 9/11, before Putin came to power in Russia, and before China was admitted to the World Trade Organization. There was a level of confidence and happiness in the West that hasn’t existed since; and that’s before we even mention this once-in-a-century pandemic.
That said, if you want signs of 2000-caliber excess, they’re out there.
Then there is the rise of the initial public offering (which veterans of the dot-com bubble will remember well). Companies no longer go to market without profits or revenue in prospect. Instead, special purpose acquisition companies, or SPACs, raise money, promising to buy companies that have profits or revenue. A chart, indexed to the day in July when the IPOx SPAC index was initiated, shows how IPOs were already outperforming the S&P by midsummer, and SPACs have poured on the performance since. An awful lot is being taken on trust.
Then of course there is the issue of valuation. The S&P 500 is trading at a higher multiple of sales than it did at the top of the dot-com bubble, while its prospective earnings multiple is almost at a record. Valuation doesn’t help with timing; it does help us gauge whether a market is good value, and US stocks are not.
The US is markedly more expensive than stocks in the rest of the planet, in part because of tech. But relative to their own history, valuations in “EAFE” — Europe, Australasia and the Far East, or the developed world outside the US — look almost as over-extended.
Yes, rates are very low, and there is overwhelming consensus that central banks will keep them that way. Stocks are priced on that assumption. It wouldn’t be good if rates were to rise.
Despite all of the above, volatility hasn’t gone away. The CBOE VIX index, which measures equity volatility via the options market, dipped sharply once the election was over and Pfizer Inc. had announced positive test results for its Covid-19 vaccine. But there has been no follow-through. The VIX appears to be settling into a “new normal” at about 20, having spent most of the four years ahead of the Covid shock at about 10.
In one sense this is positive. It shows that markets haven’t fallen victim to 2000-style complacency. But the combination of record valuations with elevated nervousness isn't healthy.
One trade nearly made it into the Hindsight Capital round-up for 2020, and it was very simple. Betting on the Bloomberg Commodities agriculture sub-index while shorting the energy sub-index would have made you 110%.
We know about the problems for energy. Food prices have risen sharply in the last few weeks ahead of signs of a poor harvest for soybeans in South America (which would increase the price of animal feed). Liquidity-driven demand in emerging markets can also lead to higher food prices. In China, India and other emerging markets, rising food inflation can be very dangerous. There was a major spike ahead of the global financial crisis, which overlapped with a surge in energy prices as emerging markets boomed. That led to social unrest. A second spike in late 2010 helped to spark the “Arab Spring” uprisings.
Weak demand, shown by low oil prices, combined with food inflation could yet upset emerging markets, from which much is expected this year.
Against this, developments in solar power are radical, and seem to have passed many by. As Hindsight Capital showed, buying solar energy stocks last year worked out very well. Despite concern over climate change, they had been in the doldrums almost without a break since 2007.
What makes the current rally more remarkable is that it has co-existed with a fall in oil prices. Generally, solar stocks need higher oil, as this sharpens the incentives to find an alternative. A rally while oil prices are low suggests genuine optimism about the industry.
Bloomberg
