The Market in Purgatory

A trader works on the floor of the New York Stock Exchange in New York City, July 28, 2021. (Andrew Kelly/Reuters)
Financial markets are caught between the countervailing forces of recovery and retrenchment.

Scenario analysis is widely used in financial forecasting. Because the future is unknown, it makes sense for a forecaster to outline all the possible market outcomes (scenarios) and to then decide which course of action is most appropriate.

But there is a part of Wall Street that has come to believe that, thanks to the Federal Reserve, such a painstaking exercise may well be a waste of expensive analyst time.

After all, for at least 27 years (if we count the Brady bond bailout as a starting point), the Fed has been almost unfailingly willing to intervene to shore up markets. This engendered a reflex among investors, which may not be healthy, but is at least predictable: Remain relaxed when markets go up, but expect the Fed to intervene aggressively when markets go down. When stocks go up, investors believe that they will continue to go up. And when they go down, investors believe that they will recover quickly because the Fed will pour trillions of dollars on the problem. It’s a win-win. Don’t fight the Fed.

So we could make this article short on the basis that the market will always go up, save for the occasional 10 or 20 percent retracement — a “healthy correction” in the delightfully soothing phrase. Buy and keep smiling. End.

Or we could consider the lessons of history and leave some room for the possibility that there are other scenarios out there, not all of which will enrich stockholders. To say that the signs are everywhere is trite because the signs are everywhere. But let us consider some scenarios:

The first scenario is still the most probable, for no reason other than it has been the most probable for a long time. It is one of a continuing bull market. Sure, stocks are expensive in growth sectors, but they offer good value in many others such as energy, travel, retail, and industrials. According to Yardeni Research, the valuation gap between growth stocks and value stocks now stands at about three times its historic 10-year average, a divergence that was last seen during the 1999–2000 NASDAQ bubble.

Bonds are now unattractive. The 10-year Treasury yield has fallen back to well below 1.5 percent and higher-risk corporate bonds also look extended. So where other than in stocks are investors going to put their money?

Yes, real estate is another part of this bull market and prices are rising rapidly in that sector too. And yes, the value of art (paintings, photographs, sculptures) is said to have outpaced the stock market, but this assessment ignores the fact that trading in art involves much higher commissions and takes place in a far less liquid market, in particular in times of distress. Stocks therefore will remain the destination of choice because transactions costs are low and because the market is deep, varied, and very liquid.

Currently, nearly all analysts, fund managers, and strategists are sticking to this first scenario. In their view, the market is going up, period. They see their job as advising their clients on which individual stocks will outperform the market. If we judge by the results, their advice is often faulty. Very few efforts at stock-picking generate returns in excess of the market’s for prolonged periods. The reason is usually that top analysts and top money managers tend to overstay in stocks and in sectors that have performed well and eventually lose ground rapidly when those sectors fall out of favor. Active managers (stock pickers) have underperformed market indices for eleven years straight.

The second scenario is one of inflation that is not, as the Fed puts it, “transitory.” Such a realization would quickly complicate matters due to two factors: Nominal interest rates are very low and real rates are already negative. If inflation sticks at 5 percent for example, an elevated but by no means extreme level, the nominal rate on the 10-year Treasury would have to jump from 1 percent to 6 percent in order to yield a 1 percent real return. It is possible that stocks would still outperform other asset classes under this scenario, but probably not in the initial phase when panic could drive everything down 20 percent or more.

A few older investment professionals may be less sure than their younger colleagues that the risk of this second scenario can be discounted. Their experience of past cycles has taught them a lesson or two, of which the most important is that markets, sectors, and indicators move in cycles even when the underlying long-term trajectory for the leading indices remains upward. If that experience still holds good, we will experience some dislocations in the next few months, if not in 2021, then in 2022.

The market is now in a sort of purgatory because the pandemic in the U.S. is over and not over at the same time. It is mostly over for the vaccinated, but it is still raging among the unvaccinated because of the Delta variant. If we were still in a full-fledged pandemic, the market would be selling off hard as it did in March 2020. And if we were completely past the pandemic, the market would resume the sharp sector correction from growth to value names, from technology and pharma into “reopening” plays such as travel, retail, and energy. But we are in neither place today. Instead, we are in a purgatory between pandemic and post-pandemic, without being completely in either. For this reason, growth and meme stocks that rode the liquidity tsunami of 2020–21 are now showing new vigor, with investors hoping for another giant wave. Meanwhile, since the spread of the Delta variant in the U.S., many of the reopening stocks that had performed strongly after the vaccine announcements of last November have retrenched by 10, 20 percent or more.

The market’s performance over the next few months therefore will hinge on inflation and on the pandemic. And this brings us to the next two scenarios:

Moving past the pandemic would mean that the Delta variant has been pushed back and that a full-scale reopening is reviving all areas of the economy. In this case, interest rates would rise back towards 2 percent and beyond. The place to be will be in cyclicals, industrials, retail, travel, hospitality, and energy. High-flying technology would be held back and meme stocks would be deflated. This would in many ways be a return to normality.

On the other hand, in the event of a reversion to something akin to a “full” pandemic (due to the Delta or another yet to emerge variant), interest rates would remain low or fall further. If economic activity recedes again, the entire market could fall back significantly. But massive amounts of excess liquidity looking for a home could lead popular growth names, such as the FAANG+M (Facebook, Amazon, Apple, Netflix, Google, Microsoft) to reach even more extreme valuations.

The market is in an unprecedented no-man’s land and the future intensity of inflation (transitory or not) and of the pandemic will determine its trajectory for the rest of this year and for 2022.


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