By Veronica A. Fulton, Research Analyst – GLOBALT Investments
“It is easy enough to burst a bubble. To incise it with a needle so that it subsides gradually is an operation of undoubted delicacy.” – John Kenneth Galbraith
We find ourselves wanting to use the words “most”, “ever”, or “all time” when we want to quantify the magnitude of extremes we are seeing within the market and economy. Despite these extreme levels of divergence, high valuations, and unprecedented monetary and fiscal intervention, our diligent and cautious approach allows us to navigate any market environment.
Market & Economy
Underneath the surface, the market is narrowing. The S&P 500, Dow Jones, and Nasdaq each posted all-time highs recently. Yet indicators such as the high-low index and advance decline line show mixed breadth with a small group of stocks driving the performance. Fundamentally, growth stocks should outperform value stocks in this low interest rate environment. This has not been the case for small-cap, with the Russell 2000 Value up over 25% and small cap growth, as measured by the Russell 2000 Growth, up only 1.5% for the year. In comparison, large cap growth is up over 27% (as of). If both growth indices were to finish off the year right here, it would be the largest divergence in annual performance between the two since 1998. Employment data appears mixed as well. The November jobs number as measured by the household survey added 1.14 million workers, a number not seen since last year, and prior to that 1990! However, the establishment survey came in below consensus, adding only 210,000 for the month. Divergences between the two surveys can occur; however, one of this magnitude is not common.
Implications of Inflation
The total U.S. equity market value relative to gross domestic income (a proxy for economic value) is well beyond its trend level as quantitative easing allowed the market to outpace the economy. Corporations have managed to soak up the liquidity and pass the inflation costs to consumers in order to grow profit margins to levels not seen since 1950. Despite the huge gains for companies, wages as a percentage of company earnings are at an all-time low, and real wages are steadily decreasing with each incremental increase in inflation. Economic data consistently shows that prices are rising more quickly and for a greater length of time than previously anticipated. As a result, the CPI rose to a 6.8% year over year increase, its fastest pace in nearly 40 years, while the real Fed funds rate has reached -6.14%, the most negative it has been since the 1970s. These levels have become more concerning for both investors and the Fed as they no longer appear “transitory”.
Speculation
Despite apparent distortions and sticky inflation, investors are all in. Cash as a percentage of investor’s total asset allocation is at historically low levels and margin debt is at record highs , implying both speculation and leverage are at paramount levels. Simply put, this market continues to inflate notwithstanding the huge amount of structural risk, and there appears to be nothing other than ultra-low rates and liquidity injections to support it. These extremes, accompanied by the recent spike in volatility, lead us to believe this Fed-induced bubble has become even more fragile than before. Given the current environment and its unforeseeable future, we are reminded of similar bouts in history and the origins of our asset allocation strategy. When faced with uncertainty, divergence, narrowness, and a lot of “never before seen” phenomenon, managing risks through diversification becomes important to capital preservation.
Sources: Ned Davis Research, Bloomberg, Wolfe Research, MarketWatch.com
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