Is there any sense to this bull market?
Statue in Pamplona, Spain. Photo: Vladimir Shelyapin. Source: Wikipedia. CC BY-SA 3.0.
That’s the question many folks are asking. And it’s a sensible question.
When we entered the lockdown last March – almost a year ago! – complete chaos hit the financial world. Full-faith-and-credit Treasury Notes fluctuated more than stocks; broad indices would “gap” down overnight, leading to waves of selling pressure; fundamentals were broadly discounted. No one had seen anything like this. The breakdown in liquidity reminded me of October 1987, when two-thirds of the stocks in the market simply stopped trading and most futures exchanges shut down. I worked on the 10th floor of a bank at the time, and we kept looking out the window to see if depositors might start lining up outside the lobby. Then, as in March, there seemed to be no support for the market.
Fast forward ten months, and the market seems to have no top. A new Administration promising higher corporate and personal income taxes? No problem, buy stocks. A hacker-attack that compromises the nation’s nuclear warheads? No problem, buy stocks. An insurrection at the nation’s Capital? You guessed it: no problem, buy stocks. It’s the reverse of the March pandemic panic. Stocks are “looking through” short-term dislocations to a future economy where a vaccine can restore normal life and the global economy grows to fill the gaps.
Can anything derail this freight train?
The short answer is, yes. Financial prices represent an estimate of the discounted present value of future cash flows. The calculation depends on the cash flows and on the interest rate needed to discount the future cash flows. Both of these elements depend on what governments around the world will do. Up until now, multi-trillion dollar fiscal rescue packages have supported consumers around the global economy, who have splurged on stay-at-home fixtures like streaming video, gardening, bread-baking, and home furnishings. And the winners keep on winning.
At the same time, central banks around the world have kept real interest rates negative and supplied adequate liquidity to the markets to ensure orderly transactions. These ultra-low interest rates mean that future earnings aren’t discounted very much. Indeed, negative real interest rates have been a fact of life for the past decade in the US, and negative headline rates have afflicted Europe and Japan for about the same amount of time. These negative rates have been a huge prop to the stock and bond markets. And low mortgage rates have supported consumers as well.
Real yield of the 5-year Inflation-Linked US Treasury. Source: Bloomberg.
But there’s nothing written in stone about interest rates staying down forever. In fact, the market had a minor “panic attack” a few days ago when 10-year Treasury Notes started yielding more than 1%. If all the future cash flows coming from future years of growth for long-duration companies like Salesforce and Snowflake and Zoom and Shopify start getting discounted at higher interest rates, their present value will fall – and will fall much faster than short-duration cashflow stocks like Exxon-Mobil or 3M or Coca-Cola will make it up. It’s possible, in such a scenario, to see many – even most – stocks rise but have the broad market indices fall.
How should investors plan for such possibilities – with markets that seem more chaotic and unpredictable than ever?
The same way we’ve always planned, with eyes first on our own circumstances. First, be sure to have an emergency fund of about 3 months’ expenses. We simply can’t know what will affect our employers, pensions, social security, or other sources of income we depend upon. Second, your portfolio allocation depends on your ability and appetite to take on risk. If you’re a tenured professor at a large university, your employment and income are more stable that if you’re a programmer for new start-up (or a financial professional working for a bank). Third, mind your cashflow. Budgeting your expenses so you can consistently set money aside is the best defense against a bear market. After all, if you’re investing in the market every month, you should *want* the market to go down, at least in the short term.
The big things are simple things: emergency funds, risk management, savings. This doesn’t mean they’re easy. But they do require significant attention. And maybe – if we get the big things right – we’ll be less distracted by the side-shows on Wall Street, Hollywood, Silicon Valley, or even Washington,
Carnival barker. Source: Pixabay.
What matters most is what matters to you: your cashflow, your risk profile, your budget. We don’t know and we can’t control the future. With careful planning, though, we can face the unknown with confidence.