In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them. There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.
–Frederic Bastiat “That Which is Seen, And That Which is Not Seen”
I must admit that I did not foresee pet food and golf are the two biggest winners of COVID-19 pandemic. One became the only viable outdoor sporting activity, while the other is the inevitable byproduct of all the newly acquired furry companions for people stuck at home. The benefit of foresight is self-evident; the practice is fraught with imprecision and demands constant revision. 2020 is a year full of unforeseen effects and destined to release many more.
The COVID-19 pandemic was observable as early as December 2019. When February rolled along, we were already lamenting the sorrows of Chinese restaurants and grocery stores as the isles and tables sat empty. The stock market ignored those signs and made a new high on Feb 19. Suddenly, panic happened. S&P 500 descended 30% in the next 30 days. Predictably, both monetary and fiscal authorities jumped to action, this time more swiftly than the great recession of 2008. Interest rates were lowered; bond purchases were initiated; credits were extended and finally, bailout payments and forgivable loans were widely disbursed to affected businesses and individuals. Panic gradually subsided. Vast amounts of newly created dollars, yens, franks, marks and pounds swirled in the financial markets, elevating all assets. Euphoria took hold. As the ball dropped on time square concluding 2020, the S&P 500 had advanced 18.4% to a new all-time high.
Two words are on top of investors’ concerns for 2021: inflation and bubble.
Once upon a time, there was a financial crisis. Having exhausted the conventional tools without much success, The Federal Reserve resorted to quantitative easing, which was followed by multiple rounds of more QE. Given time, normalcy returned. Whether it did so on its own or was nudged by the Fed is debatable. Neither the hoped-for reflation nor the feared inflation materialized. Inflation kills bull markets according to Wall Street lore. During the 1973 and 1974 inflation driven bear market, stocks lost over 40% of its value. On an inflation adjusted basis, S&P 500 lost 65% from its 1968 peak to the 1982 trough. During these inflationary decades, a dollar invested in 1968 did not fully recover its purchasing power until 1993. During the current pandemic, greater shares of GDP has already been spent to stimulate the economy in a much shorter time span. This amount, by the reckoning of the incoming administration, is a mere down payment. Talk is already underway for a third round of stimulus package. Even more radical ideas such as Modern Monetary Theory and Universal Basic Income are under consideration. Given the greater quantity of stimulus and the willingness to extend direct payment to citizen, the specter of inflation has become a prominent part of a conversation among history conscious investors.
Inflation or not, it is a topic economists disagree. I think even if the Fed succeeds in increasing the price of goods and services; it does not mean a repeat of the 1970s for stocks. The nature of inflation today is rather different from the 60s and 70s, which were driven by demographic factors and strong household formation. We live in the era of chronic demand shortages and exorbitant national debts. Any monetary stimuli must be accompanied by interest rate suppression, which serves to raise the price of real assets. Any inflationary pressure is due to monetary debasement, which has the illusion of raising the value of all things tangible. This may partly explain the frenzied rush of ordinary citizens to exchange their stimulus check for something the government cannot freely hand out.
We are in a stock bubble. It does not take a seasoned analyst to figure this out. The hard part had always been what to do about it. Inflation is too much money chasing too few goods, as the monetarist would say. It seems to apply equally to investable assets. The QE programs by the Fed had once again worked its magic in flooding financial markets with liquidity. But that is not the whole story. The Swiss National Bank owns almost $100 billion worth of US equities using Swiss Francs it conjured out of thin alpine air. It is merely one of many institutions around the world serving as indiscriminate buyers of stocks. For those who cannot will money into existence, it is wise to remember that buying stock is exchanging paper issued by a country for paper issued by a corporation. Stock bubbles all eventually deflate because companies can print ever-increasing amounts of stock certificates to absorb the increased liquidity. There are many similarities between the current market hysteria and tech bubble of the late 90s. When that bubble finally burst in 2000, the tech heavy NASDAQ was down nearly 40% for the year. S&P 500 was down a more modest 10%. But the value indices representing stocks outside of the bubble in fact all rose. A rotation into value is in fact happening amidst a still topsy-turvy market. Since September 2020, the long dormant value indices have woken up. Value companies are constrained by market forces from printing more stocks. The rotation to value is a rotation to scarcer and more tangible assets.
“‘How did you go bankrupt?’ Bill asked. ‘Two ways,’ Mike said, ‘Gradually and then Suddenly.’” Wrote Ernest Hemingway in The Sun Also Rises. Investors do not make laws but must foresee and be prepared for the consequences. There is only one difference between a good investor and a bad investor: the bad investor panics suddenly; the good investor acts gradually.
Dong Hao Zhang
President & Chief Investment Officer