The Levitation of Asset Prices

Mar - 1 - 2121

Lauded value investor, Benjamin Graham is quoted as saying:

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Within that framework, on February 19,2020, the U.S. stock market value hit what was at the time, an all-time high with the S&P 500 reaching 3,756. Then investors began to price in the coronavirus, which resulted in the U.S. equity markets making its fastest trip ever into bear territory with the S&P 500 declining by 34% over a five-week period ending at a low of 2,237 on March 23, 2020. The five-week contraction represented what many believed to a combination of the fear of the unknown as well as an expectation that the virus and its attendant effects would likely have a pronounced and protracted impact on the U.S. as well as the global economy and by extension would likely result in muted corporate earnings. In this article, we explore whether there has been a fundamental decoupling of the price of equity securities from the economic environment in which they operate, where it is widely accepted that this environment facilitates corporate and personal productivity, and therefore by extension should have a strong correlation to corporate earnings. And if there has been such a decoupling of equity security prices, what are the principal factors that are responsible.

To begin our examination, we turn to a number of economic factors that I believe provide a very instructive overview of the U.S. economy.
Figure 1: Unemployment Rate, 1948 – 2021
Source: The U.S. Bureau of Labor Statistics

Figure 2: Personal Consumption Expenditures, 1959 – 2021
Source: Federal Reserve Bank of St. Louis

Figure 3: Worker’s Share of Corporate Sector Income, 1979 – 2018
Source: Economic Policy Institute (analysis of Bureau of Economic Analysis)

Our analysis of the above has so far revealed a few important insights, none of which appear to be novel in their realization but when taken within the context of the current rally in equities, support the position that the levitation in equity prices appears to be dislocated from traditional economic indicators that speak to productivity: (1) the spike in the unemployment rate from 4.4% in March 2020 to 14.4% by April 2020 was the highest single month advance on record going back to 1948 and the recovery rate back down to 6.3% in January 2021 would still register as the single highest monthly rate on record going back to June 2014; (2) as a percentage of GDP, personal consumption increased from 61.8% of U.S. GDP in the 1961 – 1970 period to ~70% of U.S. GDP in 2019 and (3) when looked at as a share of corporate sector income, worker incomes represented 76.6% of corporate sector income in July 2020 compared to 83.8% in October 2008 and 84.1% in October 2001. I believe that as consumer spending has become a larger share of GDP and as the share of growth in personal consumption attributed to wage growth has declined over time, the fact that GDP is probably the strongest indicator of economic productivity makes it nearly impossible to explain the run up in equity values without looking to non-fundamental factors.

I believe the above evidence in part explains what has come to be characterized as the decoupling of equity prices from the foundations of economic reality and in so doing has transformed the equity and debt markets into this type of Rube Goldberg contraption where the Fed periodically drops another coin into the machine in order to “stabilize” asset prices and in so doing has had the unintended affect of pushing asset prices higher.
Figure 4: Rube Goldberg Original

On March 23, 2020, the day the stock market value reached its low of 2,237 the Fed announced a major expansion of its COVID-19 response, which in large measure set the stock market, together with the credit markets on a massive recovery. The move of the market higher started off with a bang – a 17.6% gain for the S&P 500 over the March 24 – 26, the biggest three-day advance in more than 80+ years and by February 12, 2021 the market had reached a high of 3,934, representing a rise off the low of 76%. Between March 24, 2020 and February 12, 2021, the market rose on 127 of the 223 trading days (57%) and on 20 of those 127 up days (16%), gained more than 1%. By comparison, during this period: (1) the U.S. unemployment rate increased from 4.4% in March 2020 to 14.4% by April 2020 before declining down to 6.3% in January 2021, which was 1.9% above the rate in March 2020; (2) continuing unemployment claims for the week of February 13, 2021 stood at 4.4mm compared to 1.7mm for the week of February 29, 2020; (3) large segments of the services sector of the U.S. economy remained shuttered or at capacity levels significantly below pre-COVID-19 levels and (4) corporate earnings for the S&P 500 declined from $141.97 per share in 2019 down to $98.71 per share in 2020.

So where does that leave us and how does one begin to explain the decoupling? The world is fighting the most destructive pandemic in a century and the worse economic contraction in the last 80+ years and yet the stock market value – which is supposed to serve as a gauge of current conditions and a barometer regarding the future – has been able to compile a record advance at a time when the economy is significantly weaker than it was pre-COVID and the prospects for the future (if future is defined as a return to “normalcy) is less than certain in terms of when that might occur.

In its March 23, 2020 statement, the Fed stated that “while great uncertainty remains, it has become clear that our economy will face severe disruptions. Aggressive efforts must be taken across the public and private sectors to limit the losses to jobs and incomes and to promote a swift recovery once the disruptions abate.” And with this positioning, the Fed signaled to the market that they were predisposed to extend a Great Recession era program of market stabilization to ward off the effects of the pandemic and made a commitment to keep interest rates unchanged near zero and to continue to purchase bonds at a rate of ~$120 billion a month.
Figure 5: Effective Federal Funds Rate, 1954 – 2021
Source: Federal Reserve Bank of St. Louis

Figure 5- Effective Federal Funds Rate 1954 – 2021

The impact of the Fed’s bond buying program has had a pronounced effect on equity security valuations because when the Fed buys fixed income securities, it puts money into the hands of the sellers of those securities and that money has to be reinvested. That reinvestment process, in turn, drives up the prices of fixed income securities while contemporaneously driving down bond yields and therefore prospective returns. This process continues throughout the fixed income asset class; as yields are compressed due to higher prices, bond investors are pushed further out onto the yield curve where riskier borrowers are rewarded with access to capital at rates that may not necessarily reflect the level of risks. Moreover, as market participants seek out more attractive returns excess capital is pushed into the equity markets, resulting in asset price appreciation and correspondingly lower return profiles. In short, the Fed’s bond buying program has transformed itself into the equivalent of “Mr. Market,” and while this is problematic enough in terms of its ability to nearly destroyed the concept of price discovery that should exist in a free market there is more – there is no reason to believe that Mr. Market is focused on good securities value, attractive prospective returns, solid creditworthiness to protect it from possible default or adequate risk premiums. Rather, the goal of the Fed appears to be to keep the markets liquid and to keep capital flowing freely to companies that may need it most and in so doing appears agnostic to asset prices that overstate financial reality. The market is convinced that interest rates will remain lower for longer and these low interest rates engineered by the Fed have several affects on the value of equity securities:

The lower the fed funds rate, the lower the discount rate used by investors and as a result, the higher the discounted present value of future cash flows, which results in an artificial increase in asset values.
The risk-free rate represents the origin of the yield curve and the capital market dividing line. Consequently, a low risk-free rate brings down the demanded return among all asset classes because when the risk-free rate is low even low returns seem attractive notwithstanding the risks associated with a particular investment.
Lower yields on bonds means they offer less competition to stocks and this is yet another way that relative considerations dominate and have the affect of pushing capital into equities and thereby inflating their prices.

The above factors have resulted in the following:

Although suspended for brief periods throughout this run, the ever optimistic “buy the dip” mentality and belief in momentum has come back with a vengeance with the large percentage of trading in today’s markets accounted for by index funds, ETFs and other entities that don’t necessarily make value judgments.
Investors have been emboldened by the fact that today’s Fed seems to offering up a “Powell Put,” a successor to the Greenspan Put of 1990s/early 2000s and the Bernanke Put of the Great Recession. The belief in the Powell Put stems from the belief that Mr. Market has backed itself into a corner and now has no choice but to continue to play the role of liquidity provider in order to keep the credit markets open for borrowers and in so doing is also playing the role of pushing asset prices higher.
The rise of the retail investor and the democratization of the capital markets have played a part in contributing to some of the equity market’s most irrational run up in valuations.
Equity fundamentals and valuation appear to be of limited relevance.

So how does this story end?

There is no way to determine for sure whether a market advance has been appropriate or irrational and whether markets are too high or too low. But there are certain questions worth asking whose responses can serve to begin to frame the outline of a viewpoint:

Are market participants weighing both the positives and negatives of investment opportunities?
What’s the probability the positive factors driving the market will prove valid when compared to comparable downside risks?
Are the positives attributes fundamental (value – based) or largely technical, relating to inflows of liquidity and if the latter, are these factors likely to prove temporary or permanent?
Is the market being lifted by optimism causing investors to ignore valid counterarguments?
How do valuations based on metrics such as earnings, sales and asset values compare to historical norms?

While I cannot say with certainty when any correction may occur, my answers to the above questions lead me to the conclusion that the market rally we’ve seen off of our March 2020 lows has been built on optimism; has incorporated positive expectations about a return to normalcy while overlooking potential negatives; and has largely been driven by the Fed’s injections of liquidity and the Treasury’s stimulus payments, which investors assume will bridge to a fundamental recovery in the economy. I am a bit more skeptical.

“At the root of all financial bubbles is a good idea carried to excess.” ~ Seth Klarman

Recent Insights

By Subject

By Month

Get Newsletter Updates

Time Frame Matters – Part I: The Inflation Paradox

Mar 15, 2021 | Inflation

In this article I explore how certain demographic risk factors have created structural changes to the U.S. economy that if left unaddressed from a...