HIGHLIGHTS

• The US was up by 3.31% and international 1.85%. The Dow and the S&P 500 close at record highs.
• The 10-year increases by 8 basis points and the 30-year by 12.
• The $1.9 trillion stimulus package is now law.
• Every adult in the US will be eligible for a vaccine by May 1 according to Biden.
• Henry Kaufman worries about the market’s reliance on the Fed…
• …and their independence
• Household wealth at an all-time high.
• GME soars again.

MARKET RECAP

US stocks advanced by 3.31% and international stocks were up by 1.85%. Bonds declined by 0.43% as the long end of the curve continued to see higher interest rates. The S&P 500 and the Dow closed at a record high. The Nasdaq 100, which was off its high by about 10% last week, rallied and is now down 6.3%. A massive stimulus bill and Biden’s announcement that every adult in the US can get a vaccine by May 1 fueled the optimism.

The $1.9 trillion stimulus package was passed into law. The economy was already set for strong growth in 2021, but the economy might really accelerate now with this. This is the likes of which we have never seen before, a massive stimulus package, coming on the heels of two other massive stimulus packages, plus interest rates at close to zero, and a Fed promising to let inflation run hotter than its target with no intervention.

Higher interest rates on longer-term bonds like the 10-year could force expanded P/E ratios to contract, but the bulls are counting on booming earnings to offset the lower ratio to keep stocks on the march higher.

Randall Forsyth writes in Barron’s this week about Henry Kaufman, the widely followed chief economist at Salomon Brothers in the 1970s and 80s, who has written a new book, to be released next month, The Day the Markets Roared. A reference to his call that long-term interest rates would decline back in August of 1982. That set off the rally of the 80s, 90s, and arguably beyond. Kaufman now questions the independence of the Fed. “The implication is near-term political decisions may have greater force over financial market behavior than ever before.” Going on to say that “It seems to be that the equity markets are highly dependent on the continuation of monetary ease.” Basically, we are at the exact opposite point from August of 1982. Back then, we had sky-high interest rates with a tight Fed run by Paul Volker that operated with a long-term view, whereas now, we have artificially low-interest rates, almost at zero, with a Fed willing to monetize most anything and seemingly in sync with the desires of the administration.

Household wealth soared last year by 10% to an all-time high of 130.2 trillion. Of the 5.6% increase in the 4th quarter, almost all of it came from asset price gains.

Gamestop (GME) closed this week at $264.50 and got as high as $348.50. It has declined to about $40 in February after its first incredible run. The recent rally began when Ryan Cohen, the Board member and founder of Chewy, was selected to lead a board committee to work on the Company’s transformation into the digital age. GME is symbolic of this crazy market and some of the rampant speculation that is marking this era.

SCOREBOARD

Some highlights from the week:

• 370,000 new jobs added in February, a strong report.
• GDPNow is projecting Q1 growth of 8.3%.
• The yield on the 10-year continues to rise, closing at 1.551%, down from 1.626%.
• Inflation expectations are rising, now at 2.22% based on the 10-year breakeven.
• Nasdaq is down 8.3% in three weeks and was down more than 10% on Friday morning.

SCOREBOARD

MARKET RECAP

Stocks were down by 2.86% in the US and 3.92% outside the US. Bonds fell by 0.43%. Spiking interest rates and the fear of inflation dropped stocks.

The yield on the 10-year Treasury rose by 16 basis points on Thursday to close at 1.54%. That is up by 50 basis points since January 27, about one month ago, and up from the August 2 closing low of 0.52 by 102 basis points.

What has been most dramatic is the speed of the increase. A technical indicator called the Relative Strength Index (RSI), developed by J. Welles Wilder in the 1970s does a good job measuring the speed and change of price movements. According to Wilder, an RSI reading above 70 indicates an overbought condition. Yesterday, the RSI, as measured over 14-days, for the 10-year was 85.89. An RSI reading above 85 is rare.

It has only happened three times this century, back in 2007 and 2016. It did not happen at all in the 1990s and only happened two times in the 1980s. When it did happen frequently was the 1970s when it occurred 11 times*. The 1970s was a decade of high inflation and interest rates.

The exploding interest rate makes some sense. As we have been writing about when you are spending trillions like it is nothing, something is bound to happen, whether that be inflation or higher interest rates, or both. It is too early to say if this kind of increase is a foreboding of things to come, or just a one-off. We do not want to relive the 1970s, at least in economic terms.

Interest rates have been artificially suppressed. And that has led to artificially high asset prices, in the stock market and also. It has also distorted the economy by giving a lifeline to “zombie” companies. It has suppressed the creative destruction process. So a return to a normal interest rate would be good, but not in a runaway manner. That would be too disruptive and cause a host of other problems.

Jobless claims fell to the lowest level since November, dropping by 111,000 to a seasonally adjusted 730,000 last week. Weekly claims rose as high at 900,000 in early January but have been dropping since as the job market appears to be picking up some slow momentum.

Consumer spending was up by 2.4% in January as household incomes increased by 10%, helped by stimulus checks.

SCOREBOARD

RSI Breaks 85 on the 10-Year Yield

The yield on the 10-year Treasury rose by a staggering 16 basis points yesterday to close at 1.54%. That is up by 50 basis points since January 27, about one month ago, and up from the August 2 closing low of 0.52 by 102 basis points.

What has been most dramatic is the speed of the increase. A technical indicator called the Relative Strength Index (RSI), developed by J. Welles Wilder in the 1970s does a good job measuring the speed and change of price movements. According to Wilder, an RSI reading above 70 indicates an overbought condition. Yesterday, the RSI, as measured over 14-days, for the 10-year was 85.89. An RSI reading above 85 is rare.

It has only happened three times this century, back in 2007 and 2016. It did not happen at all in the 1990s and only happened two times in the 1980s. When it did happen frequently was the 1970s when it occurred 11 times*. The 1970s was a decade of high inflation and interest rates.

The exploding interest rate makes some sense. As we have been writing about when you are spending trillions like it is nothing, something is bound to happen, whether that be inflation or higher interest rates, or both. It is too early to say if this kind of increase is a foreboding of things to come, but let’s hope not. We do not want to relive the 1970s, at least in economic terms.

*Please note we are only counting the initial reading, so if it happened on day 1, and also on day 2 and day 3 or even a few days later, like day 5, that would count as just one reading.

MARKET RECAP

It was a week like no other and one they will be talking about for the next 100 or so years, maybe more. A revolution of individual investors upended Wall Street and probably put an end to short-selling as we have known it for a long-time. It was Gamestop’s week and the story is further below.

But the entire GME episode certainly indicates that there is some wild speculation going on, and wild speculation in a raging bull market is often a sign that equities need to slow down or sell-off. Now maybe it happens and maybe it doesn’t, no one knows, but there are certainly lots of signs of crazy euphoria as we have been documenting for a while now.

For the week US stocks dropped by 3.5% and international stocks by almost 4%. Gamestop was up 66% on Friday, 396% for the week, and is up by a factor of 76 over the last year.

GAMESTOP

This is the week when Gamestop took over the financial world. It might turn out to be the greatest long trade of all time. It was when an army of individual investors took on the hedge funds and won. It has been described as the younger generation against the older generation. It has been said that this has proved that value means nothing and the story means everything, but really, at its very core, what got this stock to move, were a few value investors who saw a fundamentally mispriced stock, kept telling their story, and believed in GME, until the Reddit army bought in and turned it into something else completely, and made the original believers incredibly rich. It was not an overnight get rich story. It was a few investors who believed for years until their story took on a completely unexpected life of its own.

HOW IT HAPPENED

Keith Patrick Gill, a 34-year old CFA and accounting major from Massachusetts seems to be the investor who started it all, at least on Reddit’s Wall Street Bets. Gill was an insurance advisor for Mass Mutual, but was let go. Don’t worry though, Gill probably pocketed 35-50 million from his investment in the last few days.

Give Gill extraordinary credit for doing the research. Gill actually believes in making money the old-fashioned way, by doing intense research and finding a story that others are missing. That is what got him interested in Gamestop. Gill started investing in GME long ago, in June of 2019, when the stock was trading around $5. Gill thought GME could turn around their fortunes with new customers and new technology. Gill also was aware of very high short positions in GME, which would be a potential fuel to fire the stock higher.

Gill did an amazing job publicizing his positions and slowly over time, he turned into somewhat of a legend in the Wall Street Bets Reddit forum. But Gill was not the only one, there was a loose coalition of individual value investors that saw a misunderstood company and kept telling their story. Rod Alzmann was one of them and started a website called GMEDD.com (the DD stands for due diligence) which laid out the fundamental argument for Gamestop. Alzmann had set a bull-case target price of $169.

The other part of this set-up were the professional investors on the other side who believed Gamestop was going to follow in the footsteps of the old video chain Blockbuster, it would only be time until GME went bankrupt and ended up with a terminal value of $0. So many investors believed this argument that there was short interest in the stock of 140%. Someone who is short the stock, borrows the shares from an owner (a “long” investor), and eventually has to buy it back. The idea is to short the stock at let’s say $20 a share, and then if the company is getting close to bankruptcy or has other problems, buy it back at a much lower price, and profit on the difference. But shorting a stock is a very difficult game for lots of reasons (this would require more detail than we have space for here, contact us if you are interested to learn more). But what it all means is that there was more than 100% of interest in this stock going lower, and that meant that at some point, those shares had to be purchased back. But if the stock price started going higher, and if it went much higher, then the shorts would have to start buying back the stock in big quantities in order to prevent further losses, and when this happens, and there is not enough supply, the stock can rocket higher. That is what happened in a big, big, way. This is called a short-squeeze, and what we saw with GME this week was one of the biggest short-squeezes ever.

Somehow, over the last few weeks, other investors (speculators) took the mantle and it morphed into a “rage against the machine” rally cry, the small guy against the big bad hedge funds, and this got millions of investors to buy GME and to stick with it as if it was almost a religious experience. Suddenly, the professional shorts were on the wrong side of this incredible short squeeze. And thus, GME went higher and higher and higher, until it topped out at $483.

In the end, this will most likely end up badly for most of the investors. The stock is trading at $322 right now and it is probably worth much less, and not everyone is going to get out at the top, it is just impossible. Lots of people will end up holding the bag, and those will be the losers. When that happens, who knows, maybe GME rallies another $500 from here, but sooner or later, I would say it ends up much, much lower.

THE REAL REASON BROKERS PUT RESTRICTIONS ON TRADES

On Thursday, Robinhood and other brokerages either stopped clients from purchasing more GME or put on restrictions. There were lots of conspiracy theories and politicians and others jumped on that theme to push their individual agendas, and to put their followers into more of a rage, but the truth is, during extreme periods of market volatility, brokers often have to put an end or at least slow down the party. This was not the first time and it won’t be the last.

Here is why, when someone buys stock through Schwab or TD or Robinhood or anyone else, they are buying on credit. The client owns the stock they just bought instantly, but they don’t pay until two days later. This is what is known as “T+2 settlement.” The seller is exposed to credit risk for two days. Someone who bought GME for $150 on Tuesday may not show up to pay for the stock on Thursday if GME had dropped to $10. Normally, this is not a problem as stocks don’t fluctuate that wildly, and volume is not so overwhelming in any one particular issue. But in this case, GME, and others like it, were being traded at ridiculous levels of volume and potentially could have dropped to almost zero just like that. After all, this was a stock with lots of pretty smart people thinking that $0 is where it would eventually end up.

Most stock trades go through a clearinghouse for processing. The brokerage firms are members of the clearinghouses and they effectively guarantee the trades. The clearing brokers have to post collateral to make sure they can honor these trades, this would be similar to a margin account for a regular customer. With all of the volume and all of the volatility, the collateral was getting way too high and risky for some of the individual brokers, and they simply had too much risk on the table. They needed to slow down the trades to put a temporary tap on their downside exposure until they could recalibrate. The brokers were actually doing what was needed to prevent a systematic breakdown of the system in the event of a disaster.

The Depository Trust & Clearing Corp (DTCC), which operates the clearinghouses for U.S. stock trades, said that the trading in GME (and others) had “generated substantial risk exposures at firms that clear these trades” and that the trades were “predominantly on one side of the market.”

That is why Robinhood had to quickly raise $1 billion.

Had they not put on restrictions, and had a worst-case scenario ensued, the brokers would have gotten ripped by politicians and regulators for letting the situation get out of control and putting the entire economy at risk. Instead, they did what was probably the prudent action to safeguard the system, and are now getting attacked and ripped by the regulators and the politicians for a different reason. So they were damned if they do and damned if they didn’t. But they probably did the right thing given the risk.

SCOREBOARD

Scoreboard

MARKET RECAP

Stocks went up, what else is new, by 2.37% in the US and 4.36% outside the US. But that was not the big news this week, not close. In one of the saddest displays in US history, a Trump-inspired mob invaded/attacked the halls of Congress while the Senate was conducting its ceremonial duties of making the electoral college vote official. The proud US tradition of a peaceful turnover of power was briefly interrupted, and if Trump’s previous actions did not warrant it, his reputation will certainly be ruined forever by this act and deservedly so. We wrote back on September 25th that Trump would not commit to a peaceful transfer of power and that this was “another reason why he is unfit to be President.” He definitely deserves to be removed from office via the 25th amendment or impeached, although this is unlikely to happen with just days remaining in his term.

Trump’s actions earlier in the week probably cost the Republicans the US Senate. The two Georgia Senate seats went to the Democrats by narrow margins. Earlier in the week Trump was recorded asking Georgia officials to find another 11,000 votes so that he could suddenly and retroactively win Georgia. The Georgia officials would have none of it and made it clear it was a fair vote, both the Presidential contest and the Senate runoffs. However, Trump trying to fix the election, the very thing he has falsely accused the Democrats of, probably cost the Republicans the necessary margin to win one or both seats.

So now the Senate is 50-50, with Kamela Harris giving the Democrats the edge. Hopefully, the small 51-50 advantage will be enough to keep Biden’s policies more towards the center-left than the extreme left. Biden has already indicated he is going to go for lots of fiscal stimulus, thereby throwing the country deeper into debt. As they say, a trillion here, a trillion there, and soon you are talking about real money!

Well, real money it is, although the value of that real money is declining at a fast clip. The dollar is down 9.53% since March.

In fact, there is so much money around, that the market just goes up every day no matter what happens. When it looks like the Republicans will win the Senate, the market is up. Nope, the Democrats won, ok, that is a reason for the market to go up. Employments numbers go up, we get a higher market. Employment numbers down, which means more stimulus, the market goes up. A violent mob overtakes the Capital, no problem, stocks just continue to rise. If this isn’t stock market euphoria then what is? It just feels like the market will go up every day, which of course, is often when the market is most dangerous. But practically speaking, this can go on for much longer or it can end tomorrow, but every day the market rises futures returns are declining.

The stimulus that was just passed has not even fully been distributed yet. Applications for the PPP portion are not even available yet. And then you will have a second tidal wave of money with Biden’s new fiscal stimulus. So if the past is an indication of the future, equities will have plenty of fuel behind them.

Somewhat of an offset to an even higher stock market could be rising interest rates, higher taxes especially in the corporate sector, increased regulation, and the economy itself. When corporate tax rates were cut at the beginning of the Trump turn, stocks rallied as suddenly every dollar of revenue generated was suddenly worth a substantial amount more. And while Biden probably won’t increase taxes on corporations all the way back, whatever he does increase is coming right off the bottom line.  That immediately raises p/e ratios unless prices adjust down. And then deregulation over the last few years has had a substantial impact on improving the fortunes of business. That now goes into reverse. And finally, the economy is slowing. The US lost 140,000 jobs in December, the first decline since April.

International markets seem to be overtaking the US recently in terms of equity performance. In the chart below, which compares the overall US stock market (VTI) versus outside the US (VXUS) when the solid black line is rising, the US is outperforming, and when falling, international is performing better. Over the last few months, the US seems to have topped in terms of relative strength and in recent weeks international stocks have outperformed. This might be reversing years of US outperformance.

Interest rates rose sharply during the week as the Democrats swept Georgia. The yield on the 10-year was up by 20 basis points.

SCOREBOARD

MARKET RECAP

You can make a good case that the only good thing in 2020 was the stock market, that, and the triumph in science in quickly creating a vaccine. In a year marked by a global pandemic, a literal stop to the entire US economy, stocks turned in an amazing performance. The S&P 500 was up by 18.33% for the year. International stocks advanced by 10.67%. Massive government intervention, on a scale never seen before and in dollars never imagined, including dropping interest rates to nothing, powered equities here in the US and worldwide.

A lot of the gains in the index were powered by the technology leaders like Apple (+82%), Amazon (+76%), and Netflix (+67%). When looking at the S&P 500 and calculating on an equal-weight basis, the market was up by 12%, still very impressive.

US stocks have now been up ten times in the last eleven years and have put in double-digit gains two years in a row.

Needless to say, on an absolute basis, ignoring low-interest rates which might provide justification, valuations are high. The hoped-for and long-anticipated recovery is going to have to shift into high gear to catch up to current valuations.

Looking forward at 2021 earnings estimates, stocks sell at a price-earnings ratio of 22.46. That is high. The median stock in the Morningstar coverage universe now sells at 109% of fair value, which is the second-highest amount going back to 2007. But as we said above, with interest rates at incredibly low rates, there is some justification for elevated valuations based on traditional metrics.

There are signs of euphoria in the market. IPOs that soar to ridiculous heights (DASH and ABNB), Tesla up by 743%, Bitcoin is at $31,882, up by 354% since August. SPACs (special purpose acquisition companies) or blank-check companies proliferated in 2020, there were 248 that went public last year. Here you have investors buying in on the hope that the SPAC can find something worthwhile to purchase. You are not buying an income-producing or revenue earning business, just a hope that your SPAC can find one.

As far as the economy, the US continues on the rebound path but has slowed of late due to the surging virus. Vaccines by Moderna and Pfizer are slowly being rolled out, and everyone in the US should be able to receive a vaccine by September if they want one. With or without the vaccine, the growth of the virus should begin to taper down within a few months, at least based on past pandemics.

Retail sales were up by 2.4% between November 1 and December 24 compared to the same period a year prior. Online sales soared by 47.2%. The National Retail Federation had been expecting an increase of at least 3.6%. There were winners and losers. Department store sales fell by 10.2% while furniture was up by 16.2% and home improvement by 14.1%.

Between trade issues with China, and Covid, companies have been evaluating their supply chains. Some businesses are considering bringing factories closer to home, others spreading out factories around the world so they don’t have to rely on just one facility. In either case, the net result is going to be less efficient supply-chains, which would be a contributing factor to higher inflation down the road.

High inflation down the road, from a declining dollar, from the government dropping money everywhere, from less efficient businesses, wherever it might come from, represents a threat. That would mean higher interest rates in a world where the US deficit has simply grown way out of control. Or, if the Fed suppresses interest rates, the possibility of runaway inflation and a plunging dollar. Counterbalancing higher inflation is a population that is getting older, that will save more than it spends, and improved productivity from better technology.

In the meantime, the market continues to move higher. That can change on a dime, but momentum is currently positive.

SCOREBOARD

MARKET RECAP

Stocks were basically flat in the US and down 0.55% outside the US. The action has been in small stocks, which are at a record and are up by 25% since November 5.

After months of negotiation and congressional approval, Trump suddenly decided he didn’t like the stimulus bill, but the market wasn’t disappointed, figuring congress will now come back with an even bigger package. Trump wants $2,000 in direct payments instead of $600. In a world where debt doesn’t seem to matter, why not (according to Trump)?

Household spending fell in November for the first time in seven months, down 0.4%, more evidence that the virus is taking its toll. Household income dropped by 1.1%, the third decline in four months. Consumer confidence is falling, down by 4.3 points, according to the Conference Board. However, income is up 2% since February, and savings rates are at historically high levels. So whenever the virus gets under control, there is the possibility of pent-up demand will increase economic activity. The Atlanta Fed’s GDPNow model is projecting Q4 growth at an annualized rate of 10.4%.

After four years the finishing touches are being put on a Brexit deal that would govern trade, totaling almost $900 billion, between Britain and the EU. The deal, for the most part, would allow tariff-free trade between the two sides and reduce paperwork at the border. It would also allow Britain to sign free trade deals with other nations.

SCOREBOARD