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The state of stocks: July 2021

2021-07-04, Michael Thompson

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The state of stocks: July 2021

US consumers stockpiled over two trillion dollars of excess savings during the pandemic (and worldwide consumers saved an extra 5 trillion). Many individuals are itching to spend this excess savings after being mostly trapped at home for a year. The only thing holding them back may be high prices—home prices have risen 13% in the last year, many car models have risen 30%, and airfares have risen 35%. With inflated prices comes the threat of rising interest rates and labor costs, which could be problematic for stock prices. In this article, we’ll discuss these and other issues looming over equities today.

Inflation and interest rates

We’ll start with the two most discussed issues: inflation and interest rates. We combine these factors because they are linked—the Fed adjusts interest rates in response to inflation (but also due to other factors like unemployment). If they feel inflation is high, they are more likely to increase interest rates. The idea is that higher interest rates discourage people from borrowing money to buy things, decreasing demand and therefore prices. However, the de facto method for valuing stocks (DCF) is sensitive to interest rates—higher rates reduce the current value of future earnings (and thus reduce “fair” share prices). So if inflation overheats and the Fed raises interest rates, equity prices are more likely to drop.

We’ve benefited from a decrease in interest rates over the last forty years. Each lowering effectively boosted the present value of company earnings, which boosted equity prices. This partially explains why stocks have performed so well (even better than company fundamentals) for so long. This is also why stocks appear to be so expensive today—metrics like P/E ratios are very high compared to historical values, but they should be higher in a lower interest rate environment. In effect, equity prices are higher (less attractive) because their competitor—bonds—is less attractive.

Unfortunately, if the Fed keeps their promise to avoid negative nominal rates, this equity-boosting trend of decreased interest rates may be over. The big question is exactly when and how interest rates will move in the coming years. It seems the answer will depend on a combination of inflation and employment. The Fed views recent inflation as “transitory”—a short bump in the road in the recovery from COVID. They claim this bump won’t impact rates, which will remain at current levels until 2023. However, they estimated 2024 just a few months, so it’s reasonable to question these dates.

Many experts think the most significant inflation risk is simply the fear of inflation. Without this inflationary psychology, they think the Fed will be roughly correct—a bump in the road—allowing interest rates to stay flat for a longer time. However, both April and May 2021 inflation numbers exceeded their expectations, so again we can't rely too heavily on these predictions (inflation is notoriously hard to predict). A temporary spike in inflation due to a combination of excess savings, pent up demand and base effects (i.e. compared to last year as a base, when demand for many goods/services was substantially depressed) was expected and has been realized. However, other factors may be more problematic.

Further inflationary pressure has been provided by shortages, particularly of computer chips and labor supply. Computer chips are used in 169 industries now, many (like soap) you wouldn’t even think of. Not only will this leave you paying more for many products, but many businesses that need the chips have to slow production, idle plants, and possibly lay off workers. Experts expect these shortages to continue for the rest of 2021, and the CEO of Intel doesn’t expect this to be resolved until 2023 . Many companies have reported cost increases that they’ve not passed on to consumers yet, another potential inflationary pressure.

Globalization

Like falling interest rates, increasing globalization has boosted equity returns for years. Businesses have been able to purchase parts and labor at cheaper prices due to worldwide competition. Now that risks of globalization have been exposed, companies are spending more money to diversify their supply chain and/or produce things locally. While this should reduce many risks, the higher prices will likely hurt earnings.

Volatility

Since COVID, actions by the Fed and treasury have led some to believe they will save markets, no matter the cost. This, in turn, has encouraged many to take added risks. For example, margin debt (the amount investors borrow to invest in the stock market) is continuously reaching all-time highs nearing 850B USD at the time of this writing. High margin debt typically precedes volatility, as seen in both 2000 and 2008. Investors buying extra shares on margin can pressure prices higher and, if/when a drawdown occurs, margin calls (when lenders sell borrowers stocks to reclaim their capital) can magnify the drop. Adding to this, there’s a growing portion of younger, less experienced investors in the market today using apps like Robinhood to frequently buy/sell stocks. If the market goes sour, these investors may have “weak hands” and sell into (and magnify) the drop.

COVID19

Many of us in the US are fully vaccinated and moving past COVID19. However, outbreaks around the world can still substantially impact the economy. These outbreaks limit both the supply and demand of goods/services, creating less stable earnings with more volatile consumer prices. These outbreaks also produce mutations that may evade current vaccines, risking new lockdowns even in highly vaccinated countries. While we seem to be past most major COVID complications, unexpected setbacks could thwart economic recovery.

Other threats

There are innumerable other threats to the economy and markets. Racial, political and wealth divisions could result in crippling unrest. Cyber attacks, whether from other nations or smaller groups, have already proven the ability to cause significant economic disruption. Wars, climate change and various natural disasters have the ability to wipe out businesses and lives with little warning. While each of these risks alone is unlikely, collectively they pose a non-negligible threat.

Conclusion

We’ve discussed risks and things to consider when buying equities. Most important is probably the inability to substantially lower interest rates from today’s levels. While we don’t see reason to panic, there are reasons to be cautious and maintain an appropriate level of diversification, based on your scenario. It’s unlikely that equities will produce historically high returns over the next decade as the benefit of interest rate reductions and globalization weaken/vanish. However, we think equities will continue to be the best asset class for most investors.

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