ur investment thesis for 2020 has been “Betting on a Bubble” in US equity markets (see our Strategic Insights dated January 6, 2020). We formed that thesis at the beginning of the year when the Federal Reserve was “only” printing $1 trillion to finance US government deficits. They are now on track to print as much as $5 trillion.
We believe that US equity market valuations are relatively expensive, and earnings growth will be disappointing for most companies. For equity markets to keep moving higher, valuations will have to approach “bubble” era levels, in our opinion.
Despite our concerns about valuation and earnings growth, we believe the Fed’s willingness to finance unprecedented deficit spending could keep driving equity prices higher and create a bubble in US equity markets.
We recommend investors position their portfolios for a potential bubble by adopting the investment strategies outlined below. These strategies could position their portfolios to benefit from a potential equity market bubble without taking excessive speculative risks, in our opinion.
Based on our experience with previous bubbles, getting portfolios positioned to benefit from a bubble is the easy part of the process. Repositioning portfolios to lower risk during a booming market is when investors tend to struggle.
Investors often become euphoric during bubbles. Fear of missing out on the market’s next big gain can overtake prudent concerns about a market correction.
We suggest investors take the time right now, before a bubble has inflated, to establish a risk management plan. In this report we provide an example of how such a plan could work. We believe a disciplined risk management strategy is an investor’s best guide in navigating the market’s periodic booms and inevitable busts.
COVID-19 infections rates have reaccelerated to alarming levels, and the nascent recovery in US economic growth appears to be stalling out. As November approaches, investors will be increasingly focused on the potential for a Biden victory and substantial increases in corporate taxes. Problems in the energy sector and at Boeing will likely continue to weigh on the US manufacturing sector.
All these headwinds suggest to us that a broad based recovery in US corporate earnings will have to wait until at least 2021. Any earnings recovery in 2021 may depend upon successful deployment of a COVID-19 vaccine before the end of 2020.
Even so, the S&P 500 is close to all-time highs and the NASDAQ is well into record territory. As shown in the chart below, US equity markets are currently trading at a Cyclically Adjusted Price Earnings (“CAPE”) ratio of about 30.6x. Equity markets have only traded at higher valuations during the bubbles of the late 1920s and late 1990s/early 2000s.
The explanation for this apparent disconnect between expected earnings and stock prices is, in our opinion, Federal Reserve policy. Since September of 2019, the Fed has been injecting money into financial markets to finance government deficits.
The COVID-19 crises prompted the Fed to triple the amount of money supplied to financial markets, from $1.2 trillion expected before COVID-19 to nearly $3 trillion year to date. Based on current proposals in Congress, a second COVID-19 stimulus bill could push the total amount of Federal Reserve money injected into the financial system to over $5 trillion.
All that newly created money must go somewhere. With 10-year treasury rates well below the expected rate of inflation, even inflated equity markets look attractive by comparison. We believe that if the Fed prints another $2 trillion as expected, stock prices will continue to surge higher and push valuations into bubble territory.
Positioning equity portfolios for a bubble is an inherently uncomfortable process. Our predisposition is to favor value investing, but market bubbles tend to defy the expectations of most value based strategies. Our bubble strategy seeks to strike a balance between our “buy low” instincts and the momentum driven strategies that tend to dominate market bubbles. The goal is to build a portfolio that participates in some of the bubble’s upside, but does not rely entirely upon a perfectly timed exit strategy for protection should the bubble suddenly deflate.
Our recommendations for portfolio positioning in anticipation of an equity market bubble include:
For more details and an in-depth rationale for these recommendations, please refer to our inaugural Markets Insights publication on July 31st.
Bubble markets are inherently risky markets. Although exhilarating on the way up, surprising few investors wind up keeping those exciting market gains. When the conditions that led to the bubble change, a bubble can suddenly deflate and take a lot of investors down with it.
We believe Fed policy will be the catalyst for any bubble. If the Fed is forced to change policy direction, any associated equity market bubble is almost certain to collapse, in our opinion.
We recommend investors not try and anticipate precisely when a market bubble will collapse, assuming we are correct that an equity bubble will emerge. Instead, we believe investors should determine portfolio values that, if achieved, will prompt them to move a portion of their money to cash.
Cash is used for our risk management strategy because we do not feel that current bond yields compensate for potential inflation risks.
The table below provides a theoretical example of how such a system might work. This example is purely for illustrative purposes and is not an investment recommendation. Investors should consult their financial advisors and determine risk management strategies appropriate for their specific investment goals and risk tolerance.
In our example risk management strategy, every 20% rise in the equity portfolio is followed by a predetermined shift of portfolio assets into cash. The idea is to incrementally raise the percentage of portfolio assets sitting in cash as equity markets rise.
This strategy automatically means that the portfolio will not fully participate in the bubble’s upside, but it provides a mechanism for locking in gains and avoiding giving them back should the bubble deflate.
The US is very likely to surpass its World War II record for both the size of the annual deficit and total debt as a percentage of GDP. The big difference between now and the World War II era is that back then we knew how to reduce our debt burden - win the war and cut defense spending.
Currently, neither presidential candidate is even talking about deficit reduction, much less proposing a plan for getting debt under control. The Fed is printing the money to make all this borrowing possible.
We believe that printing money to accommodate governments deficits will fuel asset bubbles, especially in equities, housing, and commodities. At some point, the Fed will have to ween the US government and financial markets from this dependence on printed money.
Predicting when that moment will come is extremely difficult. Japan’s experience under Abenomics indicates that governments can print money without generating inflation far longer than we might have expected. Any potential bubbles caused by the Fed’s aggressive money printing could therefore extend longer than history would suggest.
Eventually, every asset bubble across history has ended badly. We do not believe “it is different this time.” Investors should position themselves to benefit from a potential asset bubble, in our opinion. However, we strongly recommend that if financial markets provide a windfall that investors lock some of those gains away.