Paulsen's Perspective

There are always conflicting signals surrounding the stock market. Today is no exception. Valuations are extremely high, but yields are near record lows. Recent economic reports have weakened due to the winter’s COVID-19 surge, but current vaccinations (although slow) highlight how close the U.S. is to a more extensive economic reopening.

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Like the Saturday Night Live “Cowbell” skit, among policy officials and politicians, the solution to “everything Pandemic” has been, We Need “MORE Stimulus!”

Undoubtedly, the COVID-19 crisis has been a rare if not unique situation, incredibly serious, and has caused widespread and immense hardship. Due to that, we received a $2 trillion fiscal CARES package last spring, a massive increase in quantitative easing resulting in an 80% increase in the Federal Reserve’s balance sheet since last February, and a surge to an all-time-high 26% annual growth in the U.S. M2-money supply.

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As the stock market continues to surge higher in the New Year, investor anxieties surrounding excessive valuation risk are also rising. Many increasingly worry that the bull market has entered a manic bubble reminiscent of the late 1990s.

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Every year, there is plenty of investment advice on the best “buys” for the New Year! However, in 2021, it may prove just as important to avoid certain areas of the financial markets.

The current consensus forecast for U.S. real GDP growth is 3.9% in 2021, representing the fastest rate since 2000. Our prediction is for 6% growth—the fastest since 1984! Either way, due to massive policy stimulus and the expectation that vaccinations will finally bring COVID-19 under control, U.S. economic growth should be strong this year. Whether currently a bull or a bear, the fact that real U.S. economic growth is poised for a healthy advance should make everyone leery of traditional “defensive investments.”

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Bring on the New Year! Bring on Vaccinations! Bring on Re-openings! Bring on Mobility! Bring on Socializing! Bring on Freedom (from my basement)! Bye Masks, Purell, 6-feet of distancing, Quarantine, Zoom, Curbside Pickups, and Sickness! And “Farewell” to far too many Loved Ones! Good Riddance COVID-19!

Here are a few guesses, conjectures, and maybe even some stupid thoughts for the New Year.

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The stock market has received plenty of support during this pandemic. Massive bond-buying has ballooned the Federal Reserve’s balance sheet from about $4 trillion to $7.5 trillion. The annual M2 money supply has surged from 6% to 26%, and federal-deficit spending as a percent of nominal GDP has exploded from less than 5% to more than 15%. What’s more, policy officials around the globe have replicated this unprecedented support!

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The trade-weighted U.S. Dollar Index (DXY) has been weak since mid-May. This week’s downside pressure has pushed it below 90—within an eyelash of its early-2018 bottom. If it breaches the 2018 low, there is very little technical resistance until it moves down to near 80. This year, the dollar peaked above 100, so a drop to 80 would represent a significant 20% cheapening in just a few months.

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Valuation metrics consistently suggest the S&P 500 stock price index is extremely highly-priced. How far can the stock market run when it’s already at record high levels? Although its valuation relative to its trailing 12-month earnings per share (EPS) is equally excessive, the S&P 500 was similarly priced at the start of each of the last three bull markets. It is worth considering how those past bull markets prospered in the face of equally lofty valuations—do their examples provide a pathway for the contemporary bull market?

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Lately, investor-sentiment measures have become an increasing concern. Several metrics, including the AAII Bulls less Bears, the put/call ratio, CNN’s Fear & Greed Index, the smart-money/dumb-money indicator, and the investment newsletter writers’ sentiment index all suggest optimism has become excessive.

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Is the U.S. economy being battered by the winter surge in COVID-19 and increasing caution among consumers and businesses facing the pending expiration of the Cares Act? Concerns have escalated recently, as COVID-19 cases spike, major metropolitan areas announce renewed shutdowns, and government officials are seemingly unable to agree on a package for additional stimulus. Adding to the worries was a disappointing jobs report last week.

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In the last four years, the U.S. stock market has been dominated by growth stocks! During this time, growth has outpaced value by an historic amount, measured back to at least 1926. This trend has received considerable attention. Growth managers have been rewarded handsomely, while value managers have suffered multiple years of underperformance and declining business.

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Large cap stocks’ equal-weighted price index has persistently trailed the market-cap-weighted return during the last four years. Over the past 100 years, only a handful of similar moves has rivaled the magnitude of this underperformance. More importantly, beginning in September 2020, the equal-weighted index has demonstrated a Rare Reversal.

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Balanced portfolio investors face a difficult challenge finding equity alternatives that modify risk without overly reducing reward. The problem is acute because traditional choices have lost much of their historic appeal. Cash certainly lessens volatility, but, with a zero yield, its reward penalty is excessive.

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Perusing current equity-investment possibilities highlights a diverse set of choices. Focusing on only two primary attributes—relative price and relative earnings—illustrates considerable diversity among the major investment styles.

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Although COVID-19 has significantly impacted everyone, its economic wake has been unusually bifurcated compared to past crises. Since the pandemic requires social distancing, the recession and its aftermath have been concentrated disproportionately among “social and lower-earning” industries. This odd, if not unique, divergence in the economic fortunes of low and high-earning industries perhaps explains how overall real GDP, the unemployment rate, the housing industry, manufacturing activities, and other economic segments have managed to recover quickly and powerfully.

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In Minnesota, we’ve lived through a lot of COLD Winters! Could we now be headed for another doozy? The clocks have already been turned back, shrinking the daylight as the sun comes up later and sets earlier. Old Man Winter has wasted no time bringing record cold temperatures in October and snow cover, reminiscent of January, here in early November.  

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The frightening COVID-19 winter-wave has understandably intensified calls for additional action both by monetary and fiscal authorities. Indeed, if widespread lock-downs are again implemented, the economy will need another bridge of support.

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Since 2006, the value investment style has suffered its deepest and most prolonged period of underperformance of the entire post-war era. According to the total U.S. stock database from Kenneth R. French, during this nearly 14-year period, value has underperformed growth by an astounding 58% (4.3% per annum)!

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With no new stimulus package and a resurgence of COVID cases, worries surrounding the economy’s durability remain widespread. While this morning’s job report certainly helped quell some of those fears, there is actually a broadening array of economic gauges portraying an expansion that is becoming self-sustaining with or without additional stimulus.

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There is plenty to worry about of late. A record-setting wave of new COVID cases is threatening to curtail economic activities. If a “COVID Winter” overwhelms U.S. hospitals—leading to widespread lock-downs—economic growth could be significantly impacted. FAANG stocks are under pressure, sending the stock market to the low end of a three-month trading range.

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