Some highlights from the week:
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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.
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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
Stocks were down by 0.73% in the US and 0.26% outside the US. Bonds fell by 0.63%. The yield on the 10-year treasury is now at its highest level since the pandemic began, closing at 1.34%. Bitcoin burst through $50,000 and is currently trading at about $56,000.
Helped by stimulus checks, retail sales advanced by the most in seven months in January, up by a seasonally adjusted 5.3%. The increase topped all estimates and indicates strong consumer demand. The Atlanta Fed’s GDPNow model now projects a 9.5% annualized growth rate in Q1, up from 4.5%. Industrial production was also up, for the fourth consecutive month, increasing by 0.9%.
While retail sales were surging, so were producer prices, which jumped by 1.3%. That was the biggest increase in the records that date back to 2009. The rising producer prices (PPI) haven’t spilled over into the CPI yet, but it is probably only a matter of time. Now it is only one month and maybe it is an aberration, but when the government throws trillions into the economy and then wants to add a couple of trillion more, the threat of inflation has to be considered. Higher inflation would mean higher interest rates, which would make it difficult for the government to do anything other than pay off interest in the future, it would also cut into p/e ratios which could cause the market to decline. Maybe none of this happens but for those of us that lived through the 70s, it is a threat not to be taken lightly.
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MARKET RECAP
Stocks had a big week as US equities advanced by 5.25% and international markets were up by 4.95%. US stocks ended the week at a record high. It was the best week since November as investors were looking forward to a $1.9 trillion stimulus package. For the same reason stocks were up, bonds were down, falling by 0.35% as the prospects of inflation lifted interest rates on the longer end of the curve. Oil jumped by almost 9%.
Dropping virus numbers are also helping. How much the vaccination program has helped no one is sure, but the huge second tidal wave of Covid seems to be slowing, similar to what happened to other waves in previous pandemics. The Super Bowl this weekend will be a test to see if social gathering around the country ignites a rebound, but for right now, recent numbers are very encouraging.
The Democrats are moving ahead without the Republicans on a stimulus plan valued at close to $2 trillion dollars. This is after a $900 billion plan passed in December and the trillions spent earlier in the year. There is simply no concern for the out of control deficits and the debt burden we are laying on future generations. We are putting the country in a dangerous situation at some future point when interest rates rise, but nobody cares. Biden should settle for a more reasonable plan that focuses on getting the country vaccinated, helping those who are truly in need, and for targeted infrastructure investments that will have a clear positive payoff. Even former Obama economic advisors Larry Summers and Jason Furman thinks the package is too big. Summers said, “stimulus measures of the magnitude contemplated are steps into the unknown.”
The economy just does not need a massive plan like this. Most of the spending will start to hit just when most of the country will have been vaccinated and a year-plus of pent up demand will start to be unleashed. All of this deficit spending, on top of more regulations, monetary expansion, and reduced international trade is a recipe for inflation, which potentially means much higher interest rates. And much higher interest rates on top of an out of control deficit will crowd out spending on needed programs in the future and threaten the value of the dollar. The government cannot act like the US dollar is monopoly money, because if they continue to do so, that is how it will end up.
Gamestop (GME) came back to earth this week. GME closed at $63.77, down 80% on the week and down by 87% from its high last week. It is still way above where it was a couple of weeks back, but while many were smart enough to cash out, there were probably more who bought at higher prices expecting GME to go even higher and are now left with huge losses, or those that rode the stock all the way up and all the way down. Moreover, the Wall Street Bets Reddit page, where many of these “investors” got their inspiration, was encouraging/telling their followers to hold GME stock straight through and not to sell no matter what. Of course, as the losses piled on, the prevailing Reddit theme was that the system was rigged, failing to take personal responsibility for buying GME at simply ridiculous prices and without regard to any fundamentals. The GME saga is just a sign of the times.
As is Dogecoin, a cryptocurrency that is flying high and is now worth more than $6 billion. Dogecoin was created as a joke in 2013. Like it was literally created as a joke, the developer wanted to create a coin that couldn’t be taken seriously. The developer, Billy Markus, spent a grand total of three hours one Sunday afternoon creating the currency. But Elon Musk has tweeted about it a couple of times in recent weeks and it has increased in value by 80%. In addition, the Reddit crowd is aiming to push the coin to $1 from its current 8 cent value. People are buying something with an intrinsic value of $0 but that doesn’t matter. It is the same mindset that pushed GME to $500 per share, but even worse, at least GME has a business with some kind of prospects (if it can be turned around) of generating cash flow.
Payrolls increased by 49,000 in January, and the December job loss was revised up to 227,000 from 140,000. Lower labor force participation dropped the unemployment rate to 6.3% from 6.7%. All in all, the payrolls report was considered a disappointment.
Normally, home prices fall in a recession, but not this time. Prices are up sharply, rising by 9.1% year over year in November. Home prices have benefited from Covid, as city residents move to homes in the suburbs, but also by the Fed’s monetary policy, which has included buying $40 billion per month in mortgage securities. That has reduced mortgage rates which have increased demand and thus, more expensive homes. The problem is first-time home buyers and others are being priced out of the market. The other problem, which we allude to above, is that excessive monetary and fiscal stimulus is starting to lead to inflation which could be a big problem down the road.
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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.
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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.
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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.
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