Inflation as a Driver of Financial Market Prices

Victor Levinson Comments

Since the financial media continues to stress the importance of inflation on financial market prices, we will once again discuss this topic (the most recent previous coverage was in April 2021).

Inflation refers to a situation in an economy where prices in general are rising. When this occurs, the impact is that the same amount of money buys less, also referred to as a reduction in purchasing power. It is important to note that the price increases that constitute inflation are for the same goods and services; price increases due to improvements in quality or efficiency or productivity of what is being purchased are not considered inflation. An example of this is the modern day electronics-loaded automobile compared to its many predecessors.

Another significant feature of inflation is that it does not affect all people/businesses in similar ways. Some businesses may be able to charge higher prices for their goods and services, adding to their profits, while others may have to pay more for their inputs and labor, thereby reducing profits. People on fixed incomes, or those whose incomes don’t rise to keep pace with the price increases, can end up with materially reduced purchasing power, sometimes having to choose among basic necessities. For those with money to invest, inflation is often accompanied by rising interest rates. While rising rates can lead to bond price declines for some period, as time passes these rising interest rates generate additional income for investors. The relationship between inflation and stock prices has been mixed.

There can be different driving forces for inflation in different time frames. One factor is increased demand for the goods and services being produced/provided in the economy. This would normally be a good sign for an economy, as an expanding economy provides funds for business innovation and research, additional tax revenue for government to support groups that need additional assistance, and new jobs and an improved standard of living for many in the workforce. Another inflation driver is a shortage of supply, which causes/allows producers and service providers to increase prices. These types of price increase are often unfavorable to the economy, as they can make prices too high for people/businesses to pay. When this kind of inflation occurs, the US Federal Reserve (Fed) often steps in to raise the interest rates it controls in order to slow down/cool off the economy. Excessive tightening by the Fed can lead to prematurely interfering with a favorable expansion of the economy. Excessive tightening also is likely to lower bond prices, at least in the short run (see above), and may adversely affect stock prices, which typically benefit from low interest rates, as stocks and bonds compete for investor money. (NOTE: The Fed announced in December that it plans to raise interest rates in 2022, but we will hold off on writing about these changes until early next year.)

The inflation the US is currently experiencing appears to be of the unfavorable variety, characterized by supply shortages of important products and services, and labor shortages, as potential workers either pass on returning to the labor market or demand higher wages to do the same work. These kinds of factors driving prices higher with no improvement in quality are moving the Fed towards an earlier-than-anticipated tightening of interest rates, albeit at still very low levels. This tightening would be designed to slow down the economy and its current excessive, unfavorable inflation.

We expect that inflation will continue be a topic of great interest to the financial markets, and accordingly plan to keep you updated on this subject as we head into 2022.

The Importance of Asset Allocation

Victor Levinson Comments

PPA discusses asset allocation regularly in our monthly commentaries. This concept refers generally to the amounts invested in stocks and bonds, and how this split determines the risk-return trade-off as we help you pursue your long-term goals. Once we’ve established an asset allocation customized to your situation, a second level of analysis focuses on asset location, or where it makes the most sense to invest your assets in the different types of investment accounts.

First, a little background on the basic kinds of accounts used by investors:

  • Tax-deferred, or “pre-tax”, retirement accounts, which have been given special advantages in the tax laws. Examples include Individual Retirement Accounts (IRAs) and 401K accounts at work.
  • “After-tax” retirement accounts, which have different tax advantages than tax-deferred accounts. The Roth IRA is the primary example of this type of account.
  • Accounts where the deposits have already been subject to income tax. These are also referred to as taxable accounts.

Because the nature of these accounts and how best to use them are primarily a function of the U.S. tax laws, we urge our readers to confirm with your accountant/attorney how the information presented below applies to your specific situation.

RETIREMENT ACCOUNTS

  1. Contributions to various types of IRAs (“traditional” as well as SEPs and SIMPLEs, which we’ll cover in future Comments) and work retirement plans (401Ks in the private sector in addition to 403Bs and 457s for non-profits and governments) allow for current-year income tax deductions. Earned Income that is not currently taxed allows investors to earn investment returns on that money. While taxes will be paid at some future time on the accumulated retirement account values (remember that except for Roth IRAs, these accounts are tax-deferred, not free of taxes), the tax deferral essentially functions as an interest-free loan from the government to use to grow your portfolio for retirement. The more time you have until the tax laws require you to withdraw the funds and eventually pay taxes, the more valuable this opportunity becomes.
  2. In addition to these tax-deductible IRAs, there is another category of tax-deferred account, known as an IRA rollover. Transfers into this type of account are not tax-deductible, but they provide the same advantage of earning untaxed investment returns over time, until the tax laws require you to take the money.

The IRA Rollover does not offer a current tax deduction because the funds have already received the benefit of the tax deduction at an earlier point in time. For example, 401k plans at work allow employees to defer taxes on the amounts they contribute into these accounts. (Employers can also make deductible contributions to employees’ accounts, also known as “matching.”) When employees leave a job or retire, they are able to transfer all of the accumulated funds into their own IRA Rollover account, and do their own tax-deferred investing there.

  1. Roth IRAs and Roth IRA conversion accounts have the opposite tax treatment. While tax-deferred retirement accounts feature deductible contributions and ordinary income taxes on withdrawals during retirement, Roths do not provide an up-front tax deduction (hence the term “after-tax), but all of the withdrawals from Roths during retirement are tax-free. As with tax-deferred IRAs, Roths involve special rules that can merit consultation with your accountant.
  2. Unlike Roths, tax-deferred retirement accounts do require taxable withdrawals at a certain point. These are known as Required Minimum Distributions (RMDs). Starting with the year in which the account owner reaches age 72 (the start date used to be age 70 1/2), the IRS uses an actuarial table that establishes the required percentage to be withdrawn, which is then applied to the account balance as of the end of the previous year. For example, if the actuarial table indicates a 6% withdrawal for someone aged 80, and the account had $1 million at the end of the previous year, then $60,000 would be the amount of the current-year RMD. The full $60,000 counts as taxable income in the year withdrawn. Taxes must be paid even if the account owner does not need to use the money. While many people question having to pay taxes on unneeded funds, it bears remembering that this money was not taxed at all previously, including a tax deduction for the contributions and tax-deferral for all investment returns in the account.
  3. This brings us to the issue of asset location in retirement accounts. This is not an effort to pick outperforming asset classes, but rather a question of whether the tax laws deliver certain outcomes that make it preferable to invest in one asset class or the other. For example, if a tax-deferred account is used to actively trade stocks looking for gains, there would be no taxes to pay on those gains when the stocks are sold within the account. The offset to this advantage is that all the taxes due on withdrawals are considered ordinary income, so the lower capital gains rates available on stock gains outside retirement accounts are not available.

Tax-deferred accounts also offer benefits for bond investing. Taxable bonds almost always pay higher interest than tax-exempt bonds do. Since there is no tax on the taxable bond interest when held in a tax deferred account, this argues in favor of investing the taxable bond portion of your asset allocation in the tax deferred account, assuming it fits into your overall asset allocation targets.

A final consideration arguing against holding stocks in tax-deferred accounts is that these accounts do not provide a “stepped-up” cost basis at death. This provision can significantly reduce capital gains (typically associated with stocks) and related taxes, but only if the stocks are held outside retirement accounts.

  • Roth IRAs, on the other hand, can be excellent accounts to locate stocks, since the gains are not subject to any taxes, either income or capital gains, on withdrawal. Roth IRAs also do not have RMDs, since the taxes were paid at the time of contribution.

TAXABLE ACCOUNTS

These include individual and joint accounts, with many variations. Examples include transfer-on-death (TOD) and Trust accounts. The money deposited in these accounts has already been subject to income tax, so the different variations typically address gift and estate taxation, which has completely different rules than the income and capital gains tax systems.

  1. Investment returns have two sources: price appreciation (or depreciation in case of declining prices), and income generated by the investment. While this is true of investment returns earned in all types of accounts, the distinctions are much more important when investing in after-tax accounts. Historically, income is the main source of investment return from bonds, whereas price appreciation is the primary source of return from stocks.
  2. Price appreciation is the difference between what the investor paid for his/her investment, and what that investment is worth currently. A major advantage to taxable account investments with some opportunity for price appreciation is that the appreciation goes untaxed until the investment is actually sold, in which case the gain is “realized.”  Sales in taxable accounts trigger capital gains (or losses), with taxes paid at favorable long-term capital gains rates if the investment has been owned for more than one year. (Realized losses can provide other tax “benefits.”) Note the difference between this tax treatment and the treatment of gains in retirement accounts, where higher ordinary income taxes are triggered by withdrawals, not sales, no matter the source of the gain. All of this argues for stocks to be held in taxable accounts, again assuming you have one or more taxable accounts and stocks fit in your overall asset allocation.
  3. Income consists of dividends from stocks and interest from bonds. Bond interest can be tax-free or taxable, a distinction worth considering when making bond investments in taxable or retirement accounts. Tax-exempt bonds (also known as “municipal” or “muni” bonds since they are issued by State and local governments) typically pay less interest because the income isn’t subject to Federal, and in some cases, State income tax. But you only get the tax benefit of this interest income when the bonds are held in a taxable account. So while taxable bond investing makes more sense in a retirement account, if your overall allocation and tax situation calls for tax-exempt bonds, they should be held only in taxable accounts.

There are many details we have not covered in this discussion, but we want to stress the importance of asset location in the investment advice we provide you, in conjunction with your account/attorney. Please feel free to check in at any time with questions about this complex topic.

Financial Media and the Search for/Fallacy of Causation

Victor Levinson Comments

During September 2021, the three major US stock indices declined between approximately 4.5% and 5.5%, with nine down days out of twenty-one total trading days. The financial media found it necessary to attribute causes to declines of this magnitude. But the frequent price increases in the midst of declines make the effort to attribute daily causation highly suspect.

What we have seen recently are stories that mention any or all of the following to explain the declines: (A) The US Federal Reserve getting ready to raise interest rates and gradually reduce its bond-buying program sooner than expected, which in turn reduces the extreme low interest rate support that the Fed has provided to the stock market since the start of the pandemic;  (B) slowdown in the pace of economic growth, as the pandemic has lingered longer than anticipated; (C) negative impact of inflation, supply chain shortages, and labor supply shortages; (D) most recently, the possibility of US payment defaults, as Congress continues to debate raising the debt ceiling. While it is certainly possible that these factors can create plausible rationales for stock price declines, what does not make much sense are the days when prices rise even as the news remains equally negative.  And perhaps even more importantly, how are investors (i.e., those committed to long term investing, trying to ignore the short-term fluctuations favored by traders) supposed to develop any idea of the amount and duration of the decline, when prices fluctuate up and down almost every day, for the same apparent reasons?

A recent example of the media’s treatment of this subject comes from The NY Times’ “Digest” section (NYT 9/29/21, pages B1 & B2), in an article titled “Concerns About Fed Cause Stocks to Tumble”. [PPA comment: note the word “Cause,” as if anyone/any entity can explain the reason(s) for a one day move in stock prices, when there so many potential factors impacting a countless number of market participants.]  The article, in trying to explain a 2% decline for the S&P 500 index, states that “investors faced the expected wind-down of the enormous purchases the central bank has made since the start of the pandemic…. The trigger [PPA comment: note use of the word “trigger” as a synonym for the word “cause”] was a rise in the yield on the benchmark 10-year US Treasury note to its highest level since June, even though the Fed has said it does not plan to increase interest rates for months or years.” Further on the article states: “the Delta variant remains a concern for investors… [as do] rising prices… and the fight over raising the nation’s debt limit, a dispute that could lead to a government shutdown.”   The problem with all this daily analysis is that, quite often, the very next day the media needs to find reasons for gains in stock prices (see NYT Digest sections (page 2) from 10/6-8/21). This generally means ignoring the problems/causes from the earlier article purporting to explain the declines, since the problems are still all with us.

We also point to an article (NYT, 10/4/21, page B1) by Matt Phillips, attempting to answer the question posed by the headline “What Next for Market After Drop?”  “September saw the S&P 500 suffer its worst monthly drop since the start of the pandemic….in the face of a befuddling mix of signals about the next chapter of the pandemic recovery.” [PPA comment: note that “befuddling mix of signals” is another way to express the attempt to identify causes.] The article continues listing the current “usual suspects”: ”slowing growth, rising inflation, supply chain snarls, persistent threat of the coronavirus, brinksmanship in Washington, and the paring back by the Fed of its money printing programs that fueled the market’s rise over the last 18 months… All these issues have been simmering for months, but they didn’t seem to bother investors until late September, when the Fed signaled it was all but certain to start cutting back – or tapering – the $120 billion of new money it has been pouring into markets every month since the pandemic hit…. Of course, wild cards could turn the market around…”

Phillips is trying to use the recent issues confronting the markets to develop an analysis of what might occur in the future. At PPA we are confident of a few basic investing principles, one of which is that no one and no entity can consistently predict the future, any more than they can confidently attribute causation. After all, how could anyone know when investors would “begin to be bothered” by issues that have persisted for many months?

Robert Shiller (Sterling Professor of Economics at Yale, and best known for his thinking on the likelihood of the 2008 debt financial crisis) expressed his views on causation in trying to explain the current high prices for stocks, bonds and real estate (NYT 10/3/21 page B6).  “What we are experiencing isn’t caused by any single objective factor. It may best be explained due to a confluence of popular narratives that have together led to higher prices. Whether these markets will continue to rise over the short run is impossible to say….and largely beyond our powers to predict…. There are many popular explanations for these prices, but not one in itself is adequate.” Shiller first discusses the impact of low interest rates, but says that while there is an element of truth to this, it is oversimplified.  After all, the Fed has maintained low interest rates for years, following Stanford Professor John B. Taylor’s so-called simple stabilization rules. “In reality, most investors think in terms of contagious narratives that excite their imagination, not complex mathematical models, citing economist John Maynard Keynes that speculative prices are determined by intuitive guesses… arriving at a conventional basis for valuation for asset prices, and they accept it without much thought because everyone else seems to be accepting it.” Shiller goes on to warn that sooner or later, “the basis of these prices is likely to change violently as a result of a sudden fluctuation of opinion.”

Shiller continues: “Exactly when such changes will occur is the big question for investors. Unfortunately, economics provides few answers. One problem is that popular, superficially plausible theories are hard to stamp out, even if they are misguided. They keep coming back, purporting to predict the path of the stock or housing market (see also our May 2020 Comments, reviewing an important book about the life and times of Keynes). Shiller uses as an example a “tendency to think any apparent uptrend in speculative prices is a sign of economic strength that can be extrapolated indefinitely… This is an illusion…. Stories about the futility of trying to beat the markets… are generally not as lively as tales of an acquaintance making a killing on Robin Hood…. Timing is everything, yet it’s impossible to time the markets reliably. It would be prudent under these circumstances for investors to make sure their holdings are thoroughly diversified and to focus on less highly valued sectors within broad asset classes that are already highly priced.”

We would also like to highlight certain of Shiller’s ideas (see above) that we at PPA regularly comment on:

  • He too is looking for some elements of causation: “confluence of popular narratives that have together led to higher prices.” As you can see in these September 2021 Comments, PPA is highly skeptical of this endeavor.
  • Shiller also comments on the (in)ability to see the future: “whether these markets will continue to rise over the short term is impossible to say….and largely beyond our power to predict.” We would combine these two points, to be clear that what happens with short-term price changes are impossible to explain or to predict.
  • He would like to get the timing right when market valuations change dramatically, but is he confusing traders with investors? At PPA we think this is a crucial distinction, as traders use stock market price volatility to buy and sell in very short time frames, trying to make gains as prices change. Investors in contrast buy and hold stocks for extended time periods, trying to benefit from the long- term anticipated growth of the world’s economies and have their money grow to meet personal long-term objectives.

Are There Any Losers in the Financial Markets?

Victor Levinson Comments

After another month of modest, slow and steady gains in the financial markets, even in the face of what seems to be unrelenting negative news in the “real world,” we consider the existence of so many “winners” in the financial markets, compared with what appears to be precious few losers  A recent piece by Jason Zweig in his “Intelligent Investor” column” (WSJ 8/25/21), titled “Losers: The Secret History”, focused on this topic.

The following points are quoted from Zweig’s article: “How often have you been online, or viewing social media, and seen speculators bragging about the killing they just made on cryptocurrency or meme stocks? That can make it hard to remember a basic truth: You won’t be hearing from, or about, the losers. While the few who made money are strutting in the spotlight, countless more who lost their shirts slink into the shadows…. As I [Zweig] wrote in 2014, ‘When talking about their trades, losers use a muzzle while winners use a megaphone. If you hear more about profitable trades than unprofitable ones, you get a distorted view of how good that particular trader is, how profitable this kind of trading is overall, and your own chances of learning how to be good at it.’ That’s true for individual securities, for sectors and strategies, for entire markets and asset classes.  Survivorship bias – our cognitive blindness to the invisible multitude of losers – warps how we see the world of investing.”

Zweig’s article then provides a definition and example of survivorship bias as it relates to professional investment portfolio management: “An overestimate of the average past returns of financial assets or investment managers, caused by including only those that survive.  As time passes and companies or asset managers go out of business, their returns disappear from many databases, making average returns appear higher in hindsight than they were in reality.”

At Park Piedmont (PPA), we subscribe to these ideas. They seem to be alternate ways to emphasize that history is written by the winners; that past performance is in no way predictive of future results, because who among us can predict the future; and that no one consistently outperforms the broad markets — either by picking individual stocks/bonds, or market sectors, or even the broader markets. Trying to time when to buy and sell these various components of the financial markets simply doesn’t work over long periods.  At PPA, we primarily use the most broadly diversified market index investments to implement our clients’ asset allocations. But we are mindful that even this approach, by necessity, involves a modest degree of selectivity and timing that we strive to minimize. This is true because not all the investments are of one kind or done in the same time period. We also know, by the way, that Mr. Zweig also favors, at least in his public writing. low-cost, tax efficient indexed investments to develop diversified portfolios.

A further parallel can be drawn by comparing investing and gambling. Gamblers are notorious braggards when they win, and rarely discuss the times when they lose. It is often said that the worst thing that can happen to a gambler is to win the first time, because it makes them think they can win consistently. We think this is a common plight for investors as well. Perhaps they think they have some “proprietary” system or methodology that can be followed to outperform the markets, or “beat the house.” But this seems virtually impossible to implement in practice, either for amateurs or professionals.

Wishing good health and happiness for you and yours.

Asset Allocation & Rebalancing in a Rising Stock Market

Victor Levinson Comments

Asset Allocation, as our clients and readers know, refers to the diversification of an investment portfolio among a variety of liquid asset classes. At Park Piedmont (PPA), we use four such asset classes: Cash Equivalents; High Credit Quality Bonds; High Yield/Lower Credit Quality Income; and Stocks.

In times of modest market price changes, allocations that have been established to meet clients’ long-term financial and related goals, with acceptable levels of risk, can generally be left relatively unchanged. We typically consider updates if and when (A) client goals change substantially; and/or (B) market prices adjust so significantly that the portfolio percentage allocation among the four asset classes no longer represents an acceptable level of risk and reward. With this in mind, we think a discussion of recent increasing stock prices may be useful.

Using the S&P 500 index as a proxy for the US stock market, that index ended June 30, 2021, up 95% from its March 2020 low (at a time when the severity of Covid-19 became clear). The March 2020 low was 33% below the previous high reached in January of 2020. These are significant price movements in short time frames, occasioned at least in part by an unexpected event, the coronavirus pandemic. The almost incredible stock price recovery since March 2020, attributed at least in part to continuing very low interest rates and a recovering US economy as the negative impacts of the virus waned, may well create the impression of an ever-rising stock market. But this recent history should not necessarily be a reason to keep adding money to your stock portfolio.

First, these increasing stock prices may well have anticipated an economic recovery, in which case prices might already have reached their peaks, as reflected by high historic valuations (P/E ratios).

More importantly from an asset allocation perspective, high stock prices suggest the possibility of rebalancing your portfolio, which would involve reducing the stock percentage, thereby returning to the previously established allocation made in less volatile times. Such re-balancing can be accomplished either by selling stocks and buying the other asset classes (i.e., cash, bonds, or high-yield income, assuming no need to use any of the sale proceeds) or using additional cash to buy the non-stock asset classes. Selling, or at least reducing the allocation of, the asset class whose prices are rising may seem counterintuitive. But the rationale is that the higher prices get, the more extended valuations are to support stock prices, which makes some significant price reduction more likely at some point. Note this is not market timing, which involves trying to determine/predict in advance of the event when prices will rise or fall. Instead, re-balancing involves a quantitative basis for at least revisiting the portfolio allocation percentages to see if you’re comfortable retaining the higher risk asset or prefer to make some reduction to lower the portfolio risk (even in a taxable account, which is exposed to capital gains taxes).

For those interested in rebalancing, the big question becomes what to do with the proceeds from the stock sales, in a time when bonds face the threat of inflation, rising interest rates, and declining prices.

A recent NY Times article by Jeff Sommer, entitled “Higher Inflation Ahead, Don’t Try to Predict It,” (7/4/21, page B3) focuses on the difficulty even experts have in predicting the future, especially complex financial events such as the return of inflation, its timing, and its impact. Sommer also provides the following advice and information pertinent to the asset allocation discussion: “If you happen to be lucky enough to have some money to invest, relax. You do not need a crystal ball. Embrace a buy and hold strategy, setting up a portfolio with diverse, low-cost index funds, including stocks and bonds, in an appropriate asset allocation…. Add stocks to the mix if you want to take on more risk. Add bonds, preferably Treasuries, if you want more safety. It’s true that if inflation surges, bond prices could be expected to fall, but not by much. The stock market can lose more in a week than the bond market loses in a bad year.”

The article provides historical figures from Vanguard covering 1926 through 2020. A 100% stock portfolio returned an average annual 10.2% (including dividends) over that 94-year period, with declines in 25 of those years and a worst-year decline of 43%. A 100% bond portfolio returned an average annual 6%, with 19 years of declines and a worst-year decline of 8.1%. (PPA note: with interest rates still so low, earning 6% on a bond portfolio currently would not be possible, but the notion that stock prices can be much more volatile than bonds continues to be so). The article concludes that “In any case, there’s little point in worrying, because we don’t know where we’re heading. Uncertainty is part of life. We all deal with it every day. It’s when people act as if they can predict the future that they scare me.”

Another relevant article, “Wishful Thinking in a World Without Yield” by Jason Zweig (6/18/21, WSJ online), focuses on using bonds as part of your asset allocation. Zweig observes that “the challenge we all face as investors is that the collapse in interest rates makes achieving historical rates of return very difficult…. When cash and bonds yield close to zero, stacking the traditional assets on top of that isn’t enough…. But you can’t earn a higher return from alternative assets just because you need to.” The article posits three basic choices: (1) increase existing holdings of risky assets like stocks, even though no one thinks they are cheap; (2) add new and exotic bets and hope they do not blow up; and (3) grit your teeth and stay the course, through a period of what may be lackluster returns, until interest rates finally normalize. Zweig concludes that “People are looking for the silver bullet/magic wand….but there isn’t one.” (Emphasis added.)

A third article, by Neil Irwin in the NY Times (7/9/21, page B1), reviews the last few months (end of March through June 8th) of bond price changes. Irwin notes that bond prices have actually gone up as interest rates have gone down (1.75% to 1.30% for the 10-year Treasury), even with all the media attention on an expanding economy and the potential for additional inflation.

At PPA, we recognize that bond prices are vulnerable to higher interest rates. But the same higher interest rates that cause price declines also provide additional interest income, which typically offset the lower prices over time. The amount of time depends a great deal on how fast rates rise in the marketplace. Bonds also serve as a buffer to the much more extreme risk of large stock price declines, such as the period from late 2007 to spring 2009, when the S&P 500 declined by 65% while bond returns were positive. The largest annual bond price decline, by comparison, was approximately 8%. Because bond prices don’t fluctuate as much as stock prices, bonds are useful when money needs to be withdrawn from portfolios. It’s preferable not to have to sell stock when those prices might have declined significantly. Indeed, rebalancing suggests buying stocks when their prices are lower, again with the objective of returning the portfolio to its predetermined asset mix established in more normal times.

Everyone wants to be in stocks when they are rising, as now, and out when they are declining. This market timing is difficult for anyone, in or out of the investment business, to accomplish. The core concept of asset allocation is to avoid market timing by maintaining an appropriate allocation to meet your long-term financial goals within your risk tolerance.

As Larry Swedlow tells us each month, do not confuse likelihoods (e.g., stocks recover from declines, and stocks outperform bonds) with certainty. The consequences of going from rich to poor should dominate your allocation decisions. If you have already accumulated substantial amounts of money, with no real need to take on additional portfolio risk, this should provide a rationale for not adding to stocks, and maybe even rebalancing out of some stocks.

As for predicting the future direction of the financial markets, as usual, only time will tell. Our longstanding advice continues: maintain the asset allocation designed for your specific long-term goals, and try to ignore advice to make portfolio changes in an effort to time the market’s unpredictable future moves.

Impact of Government Actions on Financial Markets

Victor Levinson Comments

With financial markets showing modest changes in May, even with Inflation fears and improving economic activity continuing to dominate the financial media (see also our April 2021 Comments), we add the impact of government actions to our discussion.

While the market-based private sector dominates U.S. economic activity, there are times when government action plays a crucial role. When the Coronavirus began its spread in the U.S. more than one year ago, and many parts of the economy slowed dramatically or came to a halt, the government began the first of two major economic stimulus programs to help people pay their bills and keep businesses running. While the first program passed easily in the Congress, the second was met with much more resistance, and required a special Congressional procedure for the Biden administration to have it approved. Currently, the administration is trying to gain passage of an additional economic stimulus package aimed at infrastructure upgrades and is again meeting a great deal of resistance. Putting the politics aside, the economic argument against continuing to pass all these spending programs is that the government already has a very large debt (approximately $22 trillion; source: “Peter Peterson Foundation”), and finding the money to pay for these additional programs is likely to require some mixture of adding to the deficit, printing more money to nominally pay down the deficit (that is, adding to inflation), increasing existing taxes, and/or relying on higher future tax revenue from the anticipated increased economic activity .

A governmental budget deficit is measured annually and is not necessarily harmful. When interest rates are very low, as they have been for a number of years now, the government can borrow at low cost to engage in its economic expansion activities. But borrowing without a clear plan for repayment brings up the undesirable prospect of increasing inflation (discussed in our April Comments). This can occur when the government essentially prints new money by buying its own bonds and bonds of other issuers. When the government buys its own bonds, it increases demand for those bonds, which in turn tends to increase bond prices and reduces yields for the buyers of those bonds.

The need to raise taxes to reduce budget deficits is very often quite politically contentious. (For a highly informative and readable book on the subject of taxes, see “Rebellion, Rascals, and Revenue,” by Michael Keen and Joel Slemrod). Taxes are the way governments fund their activities, from providing for the nation’s defense and protection, educating its population, providing a safety net for its less well off, providing health care, maintaining an acceptable infrastructure, and many other functions.  While reasonable people may dispute what to spend on and how much, the basic fact is that taxation takes money from those who earn it and gives it to the government to debate about and ultimately spend. Taxpayers can be individuals or corporations, and each participant in the economy is required to participate. When taxes fall short of spending, that is when the borrowing discussed above comes into play, with the potential for more deficits and inflation.

All of these cross currents are in play every day, and very much a part of current financial media reporting. See NY Times articles headlined “Inflation is Coming, How Much, for How Long” (Jeff Sommer 6/4/21, page B8); “Roaring 20s? The Budget Forecast Has Its Doubts” (Neil Irwin 5/29/21 front page); and “The Economy is Sending Mixed Signals, Confusing Almost Everyone” (Ben Casselman 6/4/21, page B4).

For those in favor of an expansionary government with significant impact on the economy, particularly in troubled times, those advocates should also understand the potential downsides of more government deficits, more undesirable inflation, and additional taxation.  For those who favor more financial restraint from the government, they should be prepared to live in a society that might not see government perform its essential functions, which has many implications beyond the scope of these Comments.

As for the responses from the financial markets, as usual, only the future will tell. Our longstanding advice continues: maintain the asset allocation designed for your long-term goals, and try to ignore the ongoing commentary designed to get you to make portfolio changes in an effort to time the market’s unpredictable moves.

Inflation, Financial Markets, and Bitcoin

Victor Levinson Comments, Digital Assets

INFLATION AND THE FINANCIAL MARKETS

As the financial media continues to stress the role of inflation in the financial markets, we will discuss this topic of inflation here in the US. The Ibbotson 2020 SBBI (Stocks, Bonds, Bills, Inflation) Yearbook describes inflation as “the rate of change of consumer goods prices,” with the figures coming from the US Department of Labor, or DOL (pages 3-13). The Consumer Price Index (CPI), used by the DOL to measure US inflation, is made up of “a basket of consumer goods and services that are comparable but not identical” (Ibbotson, pages 1-12). The higher the rate of inflation, the more US dollars are needed to purchase the comparable basket of goods and services; this is referred to as a “loss of purchasing power.” The Federal Reserve Board (“Fed”) attempts to maintain the rate of inflation at acceptable levels, which the Fed has described as 2% annually, by adjusting the short-term interest rates it controls. It is sometimes, but not always, successful in doing so.

The connection between inflation and interest rates is key to understanding much of what happens in the financial markets. Investors seek to make investments whose returns will exceed the rate of inflation; otherwise, the investors lose the purchasing power of their money as time passes. Interest on bonds is one major source of investment return for investors looking to reduce their risks from far more volatile investments such as stocks and real estate.  If the rate of inflation goes to 2%, bond investors will expect more than 2% from their investments, to cover the rate of inflation and provide what is referred to as a positive “real”, or inflation-adjusted, rate of return.

That still leaves open the question of what makes inflation rise.  The current chain of events to higher consumer prices likely includes some combination of: 1) rapidly increasing economic activity, as the impacts of the pandemic are reduced; 2) US government programs that put money into the hands of people most adversely affected by the pandemic; 3) the need for the government to print more money and increase its deficit spending to provide such relief; and 4) supply shortages encountered by businesses attempting to meet the reviving demand from consumers.

If the financial markets anticipate higher prices (that is, more inflation), one reaction is to push up interest rates to cover the higher rate of inflation. This is what has occurred recently, as longer-term interest rates set by the buying and selling of bonds (using the ten- year US Treasury as the benchmark) have risen from historic lows of approximately 0.50% in the summer of 2020, as the pandemic continued to spread with accompanying sharply curtailed economic activity, to 1.75% at the end of March 2021. And while receiving more interest is good news for investors, in order to receive the full benefit of the rise in rates, the prices of existing, lower-interest rate bonds need to decline to provide an acceptable combined level of interest and price change to maturity (referred to as “total return”).

Inflation’s impact on stock prices can be seen as follows: if higher inflation drives up interest rates, and higher interest payments make bonds a more attractive investment, those higher rates can reduce the amount of money available for stock investing. While the long-term historical outcomes for stocks have been favorable and are mostly a function of the profits generated by the businesses in the economy, the daily pricing of stocks creates a great deal of volatility.

To get a sense for how long the annual rate of inflation causes prices to double, take the rate and divide by the number 72. Two percent inflation would lead to prices doubling in 36 years, compared to 3% inflation, which would cause prices to double every 24 years. This same “Rule of 72s” can be applied to annualized investment returns; 3% would double money every 24 years, while 5% would double money every 14-15 years. These considerations lead investors to take more risk for more return.

While these April Comments are meant to have a cut-off as of the end of April, it is worth noting that the NY Times (5/13/21, front page) reported that the CPI “climbed 4.2% in April from a year earlier… the fastest pace in a decade… even though Fed officials said the numbers reflected pandemic driven trends that would most likely be temporary.” Neil Irwin followed up with another NYT article (5/14/21, page B3) observing that “The central fact of the American economy in mid-2021 is that demand for all sorts of goods and services has surged, supplies are coming back slowly…and the question is whether current circumstances will make inflation less than temporary.”  Since inflation is such a major story for the financial media and in the political arena, we will follow this closely in the coming months.  April’s stock and bond results were both positive, even with the inflation story much more visible.

 

FURTHER COMMENTS ON BITCOIN

Bitcoin continued to rise in price through April, and public interest has grown accordingly. We will pass on discussing the complex technology, called blockchain, that underlies the creation of Bitcoin. We focus instead on whether Bitcoin is likely to gain the status of money/currency, as a recognized means of exchange, which in the long run is likely to determine whether its current pricing is simply a speculative trading bubble.

Bitcoin started out selling at one unit for a few hundred US dollars as a trinket or token in a category of purchase known today as a crypto currency (CC). During April 2021, that same one unit reached a price of $60,000 US dollars. The way Bitcoin is created (also beyond the scope of this discussion) does limit supply, which could help to maintain high prices over time. But this tremendous price volatility is an impediment to Bitcoin becoming a usable currency like the dollar, euro, or Japanese Yen. Note some similarities to using gold as a currency, although gold has a long history of being considered of value, exchangeable for then-existing paper currencies.

The claim of limited supply may apply to Bitcoin itself, but there are many other crypto currencies that have come into existence with their own exchange values. Further, government central bankers in charge of creating paper currencies can do so at their pleasure, limited only by the desire to exercise proper monetary controls and avoid harmful inflation. It should also be noted that while Bitcoin does not produce anything, or pay income in the form of dividends and interest, the same is true of most items that serve as currencies. The value of the currency is in what it will buy, its “exchange value”, for a product or service. The search for legitimate items that can serve as currencies continues, but at current exchange values, it is questionable whether Bitcoin or any other crypto currency will do the job.

A More Detailed Look at Stock Market Results

Victor Levinson Comments

In March, market interest rates, which are set by buyers and sellers in the bond market, continued their rapid rise from year-end 2020, with the ten-year US benchmark rate increasing from 0.93% to 1.74%. But even in the face of these rising rates, stock prices continued to advance. Since we have discussed rising rates, inflation, and their impact on bond and stock prices over the last few months, we thought we would change our focus this month to a more detailed look at results for different parts of the stock market.

The financial media most often reports stock price results based on the changes for a few key stock market indexes, namely the Dow Jones 30 Industrials (DJI: most of the 30 largest US companies by market price per share), the S&P 500 (almost all of the 500 largest US companies by market value, which is price per share times shares outstanding), and the NASDAQ Composite (the largest 2,500 companies by market value that trade on the NASDAQ exchange).

At Park Piedmont, we also consider stock price results and changes of these indexes, and use a Total US Stock Market index as a proxy for the entire US market when we do our stock investing. That said, a rather extraordinary and unusual event occurred with stock prices in the year 2020, as the NASDAQ gained 43.6%, the S&P 500 rose 16.3%, and the DJI increased by a more modest 7.3%. The Total US Stock Market index gained 21.0%, as might be expected from an index designed to reflect the combined results of these other three indexes. (All of these annual/annualized results, going back to 1999, are reported in our Comments each month, typically on page 5, with the specific page dependent on the length of our commentary starting on page 2.)
To better understand the huge disparity, note that almost all of the giant technology stocks are traded on the NASDAQ exchange and are therefore included in that NASDAQ Composite index. While most of these stocks are also included in the S&P 500 index, the S&P 500 includes many more stocks from other parts of the stock market. The DJI index, by contrast, consists of only 30 stocks, so that underperformance (or outperformance) by a few has an outsized impact on any period’s results. The S&P 500 exchange traded fund (ETF) (symbol SPY) has been divided into eleven sectors, each of which can be bought and sold separately from the broad-based SPY. Those sectors are, in order of their current relative valuation in the total SPY: Information Technology, Health Care, Financials, Consumer Discretionary, Communication Services, Industrial, Consumer Staples, Energy, Utilities, Reals Estate, and Materials.

The obvious question is, why not change to the NASDAQ at some time during 2020, or at least at the start of 2021, given its significant outperformance in 2020? The fundamental answer is that no one can know in advance of the outcome which part of the stock market is going to outperform the other parts. Only in hindsight is it clear which have been the best performers in any time frame. To invest by selecting what you believe will be the outperformers is essentially market timing, risking the chance of having selected the underperformers as time passes. A perfect example of this risk was the first quarter (Q1) of 2021: the DJI gained 7.8% and the NASDAQ 2.8%. The 2020 star was the laggard for Q1 2021. Also, during Q1 2021, the more broadly diversified indexes of the S&P 500 and the Total US Stock Market gained 5.8% and 6.4%, respectively, once again occupying the middle ground between the Dow and the NASDAQ.

There are other ways of subdividing the stock market into indexes broad enough to establish meaningful diversification − namely, International/ Emerging Market stocks compared to US stocks; Growth stocks compared to Value stocks; and Mid-Cap/Small-Cap stocks compared to Large-Cap stocks. Some of this discussion may become more detailed than you would prefer, so please contact us with questions.

Investing in International/Emerging Market stock indexes does provide access to the rest of the world’s stocks and their stock exchanges, which sometimes move in substantially different directions than the US stock indexes do. While US indexes contain some companies with significant international businesses, investing internationally can provide real diversification, and Park Piedmont typically allocates portions of clients’ stock portfolios in this way.

Growth and Value refer to differences in the Price/Earnings (P/E) ratios of component stocks in the various indexes. You may recall that the P/E ratio captures in one number the market price per share of a stock as it relates to that company’s earnings (profits) per share. The higher the P/E, the higher the market price will be relative to that company’s earnings. Growth stocks typically have higher P/Es than Value stocks, as investors/traders are willing to pay more for what they believe will be higher future earnings growth rates. Companies characterized as Growth or Value stocks will likely almost all appear in the broadest-based indexes, such as the S&P 500 and US Total Stock Market. For example, Apple, with a 35 P/E at $130 per share, is in the Growth index, while Verizon, with a 13 P/E at $57 per share, is in the Value index. There can be major divergences between the Growth and Value indexes. During 2020, for example, Growth rose 40.0% and Value only gained 2.2%, with the tech outperformance cited above reflected in the Growth results. In Q1 2021, Value outperformed Growth by 10.9% to 1.5%, reflecting the (short-term, at least for now) reversal of the 2020 disparity.

Large-Cap/Mid-Cap/Small-Cap is another meaningful way to divide the stock market. These terms refer to the size of a company measured by its market value. Market value is determined by multiplying the price per share of a company by the number of shares outstanding. The result is also known as the company’s market capitalization, or “cap” for short. Large companies (Large-Cap) have market values in excess of $20 billion; Apple has recently made it to $2 trillion and is still the highest currently-valued stock. Mid-Cap stocks tend to have valuations between $10 and $20 billion, and Small-Cap under $10 billion. In the current bull market starting March 2020, valuations of most companies have gained, so the value ranges related to size vary. In 2020, the Mid-Cap and Small-Cap indexes gained almost the same, at 18.2% and 19.1%, respectively, whereas Large-Cap (S&P 500) rose 21.0%. The stocks in these three size indexes can have a Growth or Value emphasis.

The various ways to divide the stock market have spawned an industry of their own, using sector/style ETFs in an effort to identify outperformers and avoid underperformers. Our purpose here is not to give you information to become a market timer, but rather to provide an initial idea of the complexities. We suspect most of you have better things to do with your time, and this applies to PPA as well. We focus on the broadest-based indexes, which include most of the stocks from the various subsets of the stock market discussed above. We also believe in “regression to the mean,” in which one period’s winners are frequently a subsequent period’s losers.

Once again, please note the chart of results on page 5 below, which demonstrate the highly variable results of different parts of the market over time. Picking winners and losers correctly on any regular basis is almost impossible, and most often ends in chasing past performance − that is, buying the outperformers just as they are about to underperform. That is why we at PPA focus on the broadest-based indexes and avoid the lure of market timing.

Please let us know if you’d like to discuss these topics further. We are here to be a resource, and to help you, our clients, continue to gain knowledge and comfort in this subject matter.

February Financial Markets in Light of Rising Interest Rates & More About Bitcoin

Victor Levinson Comments, Digital Assets

In February, market interest rates, which are set by buyers and sellers in the bond market, continued their rapid rise from year-end 2020, with the ten-year US benchmark rate rising from 0.93% to 1.40%. Many in the financial media have begun to attribute down days in the stock market to this move to higher rates. We at PPA are quick to note that these rates remain very low and do not provide enough interest income for most long-term investors, which in turn forces them to look for other, riskier sources of investment return (such as stocks) to meet their goals.

We do agree that the financial markets are impacted by rising interest rates, but those impacts are varied and often create countervailing price movements.

  1. The most direct impact of rising rates is on the prices of bonds with maturities measured in years rather than months. Invariably, those prices decline, and longer-maturity bond prices decline more than shorter-maturity bond prices do. The bond funds PPA uses in client portfolios typically consist of a mix of bond maturities, not exceeding six years, with many between zero and three years. The offset to these price declines is a rise in the interest that investors receive from their bonds. But it is important to note that it takes a longer time period for the increased interest received to make up for a potentially rapid price decline in a short time frame. Further, longer bond maturities typically pay more interest while still outstanding than do shorter bond maturities. In general, the idea that bonds mature is an important factor as to why their price volatility is considerably lower, historically, than stock price volatility.
  2. More subject to debate is whether the rising rates are signaling an improving economy. Some days the media reports improving economic conditions, like rising income and consumer spending, and other days the economic news is bleaker, with increased unemployment claims (see also page 7 for details about the improvements from the February employment report).
  3. The financial media is also focusing on the financial market’s anticipation of an improving economy based on the increasing number of people receiving a vaccination against the coronavirus.
  4. Another connection between rising interest rates and an improving economy is the conventional wisdom that if the economy grows too strongly, the Federal Reserve will step in and increase the short-term rates it controls, in order to slow the economy and avoid harmful inflation. Inflation reduces the purchasing power of a given amount of money, and if it increases too quickly and too much, central banks are tasked with controlling inflation. However, during this pandemic, “the Fed has consistently indicated its desire to keep rates low, focusing on improving the economic and employment situations, and not being overly concerned about inflation and/or rising budget deficits. The real fear of bond investors is that an economy that grows too strongly has the potential of bringing about a re-emergence of harmful inflation….Typically, when an economy has slack, as the US economy does now, growth can occur with inflation fears remaining subdued” (quoted from our January 2021 Comments).

Some additional media quotes on this situation follow:

From The Economist Magazine (2/13/21, page 10): “The debate about whether high inflation will emerge out of the pandemic is becoming more pressing… Coming price acceleration could be worrisome for several reasons. One is that it weakens the hand of those arguing for more fiscal stimulus in places that need it… The Fed has promised to keep interest rates low and to keep buying bonds because it wants to overshoot its 2% target… Higher rates also hold deep implications for financial markets. Almost everything about today’s financial landscape is premised on central banks keeping interest rates low for a long time. Cheap money lies behind the idea that the government can spend however much it likes – including Mr. Biden’s planned infrastructure bill – and underpins today’s sky-high stock market values and abundant credit. “

Fed Chairman Jerome Powell, in an online question and answer session hosted by the Wall Street Journal on March 4th (see NYT, 3/5/21, page B1), delivered the message of “how cautious the central bank plans to be in dialing back economic policies – low interest rates and large scale bond buying – that are meant to help the economy recover from the painful coronavirus shock…. Market players have begun to speculate that the Fed might lift interest rates earlier than expected, even as the central bank’s top officials pledge patience…. The Fed Chair did acknowledge watching market fluctuations,… and that sharp bond market moves would create concerns of making credit expensive, and threatening the Fed’s goals.” He also drew the distinction between a short-term pop in inflation and a sustained acceleration, as well as to note that “employers report 10 million fewer jobs than before the pandemic, leaving lots of room for a labor rebound.”

 

More about Bitcoin

In this updated discussion of Bitcoin, we begin with excerpts from our December 2017 Monthly Comments.

BITCOIN: Is it an Investment or a Currency (or both)??     

Since Bitcoin has become a very popular topic of discussion in and out of the financial world, we thought it was time for Park Piedmont to add our viewpoint. As you might imagine from a firm that advocates long-term investing with asset allocations implemented using low-cost index funds, even the mention of Bitcoin would be highly questionable. Nevertheless, we set out our perspective, then and now, below.

We start by referencing Warren Buffet, who is among the best, if not the best, investor of our time, and one of the world’s richest people. A December 2017 article from WealthAdvisor.com (http://bit.ly/wb1227), quotes Buffett as saying: “You can’t value bitcoin, because it is not a value-producing asset…” (In 2014, Buffett said, “the idea that it has some huge intrinsic value is just a joke….”).

The Wealth Advisor article notes that “Bitcoin is a complex idea. It is a virtual currency, created, owned and traded entirely online in anonymous and unregulated settings. In theory, there is a limited number of these physically non-existent digital coins, though that limit hasn’t yet been reached. A few years ago, they were almost worthless; in December 2017, their value reached $19,000.”

The article states that “what drives the value of an essentially value-free asset is – FOMO – the fear of missing out,” and explains that the intrinsic value (of an investment) is a continuous flow of actual cash from the operation of a business (referencing Buffett for this principle), and that “the ultimate source of cash flow from digital coins created on the internet is the dollars flowing from the buyers who want to own those coins, for FOMO.”

Echoing this view is Professor Robert Shiller, the former manager of Yale’s endowment, who foresaw the housing bubble of 2007-08. In a recent New York Times article (http://bit.ly/shillerbc), Professor Shiller wrote: “True investing requires a rational appraisal of an asset’s value, simply not possible at present with Bitcoin. Real understanding of the economic issues underlying the cryptocurrency is almost nonexistent…. No one can attach objective probabilities to the various possible outcomes of the current Bitcoin enthusiasm.”

One problem in Bitcoin’s potential use as a currency is the extreme volatility of its price. This was illustrated on 12/22/17, when the price went from $17,500 to $12,000 in a single day, a decline of approximately 30%. (A similar decline on the Dow Jones, at 25,000, would be 7,500 points). In the same article describing this price decline (https://nyti.ms/2DsEc97), the reporters commented that “Bitcoins have mostly been treated as an investment because there is a cap of 21 million on the number of Bitcoins that will ever be released.” Aside from the obvious question of whether someone can ensure that the cap is maintained, an even more fundamental objection to the Times article is that a numerical cap on the supply of some object does not by itself create any value in the object.  Even if self-described as a currency, why would anyone treat it as a currency without some underlying economic unit to support its value?

Investment News, a weekly magazine for investment professionals, wrote about Bitcoin (12/4/17) that “rarity can bid up prices, but even though Bitcoin limits its issuance to 21 million coins, there are some 100 other cryptocurrencies.” The article concludes that “it is hard to imagine a practical reason for owning bitcoin, aside from trading, or hiding criminal activity” (http://bit.ly/inbc124).

We now find that Bitcoin has recently reached a price of $50,000 per unit, so we can at least say that the bubble − if it is one − has lasted an additional three plus years, and is still going strong. Recently, Elon Musk of Tesla, one of the world’s richest people through his share ownership of Tesla, had his company buy $1.5 billion worth of Bitcoin, and announced that the company will accept Bitcoin as payment for its cars. Countering this news, Charles Munger, Buffett’s long-time investment partner, said he “did not know what was worse, Tesla with a $1 trillion market value (price per share times shares outstanding), or Bitcoin at $50,000 (MSNBC, 2/24/21, 3pm and 4pm).” There is also an online summary of a Private Wealth magazine article citing Bill Gates of Microsoft siding with Buffett and Munger. The same article quotes Janet Yellen, now US Treasury Secretary and former Federal Reserve Board Chairperson, “that it is an extremely inefficient way of conducting transactions.”  But the article also notes that PayPal, Visa and Mastercard are starting to accept Bitcoin as payment.

Given all this high-level disagreement, we would comment that if Bitcoin, and all other cryptocurrencies, are unable to establish themselves as currencies, it is hard to imagine how a value can be ascribed to the digital coins on their own.  Then again, thinking of the many world paper currencies used as a “store of value” whose supply can be increased or decreased at the direction of central bankers, maybe a new self-declared currency system can be developed.  What we do know is that the current system (without Bitcoin) does allow for its currencies to be traded, most of the time in a narrow price relationship, one to the other. At this time, we at PPA have no idea what the future holds on this subject, ranging from a huge crash of a price bubble to wider acceptance as a currency with a price attributed to it in relation to various other currencies.  We continue to advise against trading these cryptocurrencies, looking to sell at a higher price than the purchase price over a short time frame.

We close with our January 2021 Comments summary: “the outcome of the interplay among the benefits of the vaccine, a potentially stronger economy, a rising budget deficit, Fed interest rate policy, and possible inflation is unknown. Even if we knew the outcome, we are also aware that financial markets act in strangely contrarian ways at certain times (e.g., extensive stock price gains since March 2020, while the Coronavirus continued strong). As always, we suggest maintaining your previously established asset allocations, without trying to guess which assets will outperform others in a given time frame.”

January Markets for Stock & Bond Prices

Victor Levinson Comments

January Markets for Stock Prices  January 2021 month-end stock market figures showed little change, even though there was considerable volatility within the month. The big new news for the financial media was the action in a few small stocks that made huge gains, most likely because they were part of a so-called “short squeeze” by relatively new traders in the financial markets. There has been widespread publicity on this matter, with some observers thinking that a new financial model is at hand, while others consider it not likely to be a lasting event. We present some of the initial views on the subject.

  1. First and foremost, much of the activity was done by traders looking to profit from short-term price movements. This is much more like gambling than the kind of long-term investing done on your behalf by PPA.
  2. That said, we would explain events as follows: (A) a group of traders, communicating on social media and able to trade stocks at no cost at various online brokerage sites, identified a few stocks that had very large short positions held primarily by hedge funds; (B) short positions involve selling stock you borrow, typically from a brokerage firm, in the hope that once it declines in price, you can buy it back at the lower price, pay off the loan, and pocket the profits; (C) even if that doesn’t happen, when the position has to be covered, the short sellers must buy the stock, which creates upward pressure on the stock price; (D) since short sellers profit when the stock price goes down, and in this case they were being forced to buy stock to cover their short positions at higher and higher prices, the hedge funds suffered major losses and some were forced to close down; (E) a few firms that the short sellers used to maintain their positions had to raise new money to cover some of the short seller activity; and (F) in the meantime, many of the early buyers of the stock were being paid higher and higher prices to provide the stock that had to be delivered to the short sellers.
  3. While some in the financial media opined that this kind of trading, urged on by social media and expedited by free stock trading sites, would have a lasting impact on the financial markets, others were not so sure. Some sample thinking follows:

Kevin Roose (NY Times, 1/29/21, page B1) wrote: “This week, the biggest story in the financial markets is the absurdist, pretty-sure-I-hallucinated drama involving GameStop, a struggling video game retailer that became the rope in a high stakes tug-of-war between Wall Street suits and a crusading internet mob. The simplest explanation of what happened is that a bunch of hyper-online-mischief makers in Redditt’s r/Wall Street-Bets forum… decided it would be funny and righteous (and maybe even profitable, though that part was less important) to execute a “short squeeze” by pushing up the price of GameStop’s stock, entrapping the big money hedge funds that bet against it. The strategy worked… And even if GameStop stock crashes or regulators step in and call off the party, these disillusioned day traders will keep trying to create chaos for the elites they feel have spent decades profiting at their expense. The rebels may not win in the long run. Institutional power has a way of reasserting itself after sudden shocks… But for the Redditt day traders, the important victory was always the symbolic one. They might lose their shirts, but they have sent the message that with enough passion and rocket ship emojis, a crowd of profane, irreverent degenerates – their words, not mine – can turn the stock market on its head. The hordes are here, and Wall Street will never be the same.”

A front-page NY Times article (1/28/21, page A1) said that “no one knows how this will end…Some analysts say the intense activity could eventually prompt a wider sell-off in the market by forcing hedge funds on the losing side of these trades to sell parts of their portfolios to raise cash to cover their losses.” The article has the following quote from a Wall Street professional: “What happens in situations of stress is that people are forced to raise funds and that often means selling your winners…. How does it end? Badly. Eventually the bigger the balloon, the louder the pop…When does it end? I don’t know.”

Jason Zweig (WSJ, 1/30/21) wrote the following: “For all the hyperventilating over this week’s financial revolution, investors should regard it as the latest phase in a long evolution – and not likely to disrupt the markets overall.… Now, however, amateur traders are asserting their advantages. They can communicate instantaneously, band together by the thousands – millions, perhaps – and buy or sell commission free. Thousands of members of WallStreetBets, a forum at the online community reddit.com, have been leading the swarm of amateur individual traders buying stocks that hedge funds and other institutional investors were betting against.” (PPA note:  Zweig refers to the newcomers as traders and the hedge fund short sellers as investors. We think of them all as traders, even though the hedge funds might have a somewhat longer time frame for holding their positions).  Zweig discussed the small market value of the stocks being traded compared to the overall value of the US stock market (at $42 trillion), and also the fact that volatility in the broad stock market is only “up a bit” in 2021 so far. He concludes that “taken together, these indicators suggest the flash mobs have not had significant impacts outside the two to three dozen stocks they love to trade the most…This latest upheaval is likely to have a bigger impact on investor attention than their portfolios.”

In the midst of the extreme price gains in GameStop stock, Jeff Sommer wrote in the NY Times (1/31/21, page BU8): “The stock’s gains had nothing to do with its merits. The company is losing money, as you might expect when you look at its business model (i.e., selling physical copies of computer games at retail malls)…While there is a David versus Goliath element to the GameStop stock saga, it is likely to be a cautionary tale…Tempting as it may be to join in the fun, at moments like these most long-term investors are usually better off if they stay sober and avoid the urge to make quick profits. A better option would be salting away money in dull, well-diversified stock and bond portfolios, these days preferably in low-cost index funds.”

In the same spirit, Neil Irwin wrote in the NY Times (2/5/21, page B3): “Many of the traders driving the recent GameStop mania want to strike it rich and bring down what they view as a corrupt, rigged system along the way…. But the reality is that the stock market has offered a path for ordinary people to build wealth – and more so in the last generation than ever before. All you had to do is take the laziest, simplest approach to stock investing imaginable, and have a little patience. Ever since the Vanguard S&P 500 index fund was introduced 45 years ago, ordinary investors have been able to invest in broad stock indexes in a tax efficient manner with extremely low fees… owning a small share of the earnings of hundreds of leading companies.” The article then reviews some annualized returns based on when money was invested and concludes that “There are no guarantees in life. Index funds will not generate the kind of overnight payoffs that buyers of GameStop options are evidently looking for. And the decades ahead may offer lower returns to stock investors than the decades just past. But the payoffs of being a passive stock market investor are not something to overlook.”

The Economist magazine (2/6/21, page 9), taking a much broader view of potential changes, observed that “[t]echnology is being used to make trading free, shift information flows and catalyze new business models, transforming how markets work…. While the whiff of mania is alarming, you can find reasons to support today’s (broad stock market) prices. When interest rates are so low, other assets look relatively attractive… Yet the excitement also reflects a fundamental shift in finance…. Far from being a passing fad, the disruption of markets will intensify.”

And finally, providing balance to this early discussion, Andrew Ross Sorkin wrote (NYT, 2/3/21, page B1): “There will be academic case studies on the mania around GameStop’s stock.  There will be philosophical debates about whether this was a genuine protest against hedge funds and inequality, or a pump-and-dump scheme masquerading as a moral crusade.  Eventually we will learn whether this was a transformational moment powered by social media that will shift the investing landscape forever, or a blip that soon fades away.”  The remainder of the article discusses the public’s “deep distrust” of the stock market, and ways to overcome this feeling.

We join Mr. Sorkin in acknowledging we do not know how this will all play out over time. But we certainly hope that this kind of trading activity goes away quickly, and that those who participate become investors for the long-term, leaving the gambling to other activities (e.g., sports events).

 

January Markets for Bond Prices also showed little change, even with a rise in interest rates from 0.93% to 1.11% on the ten-year benchmark US Treasury rate. As recently as June-July 2020, the rate was approximately 50 bp lower than at the end of January 2021. Also noteworthy is that the year-end 2019 rate was about one full percent higher than that of year-end 2020.  All these rates are obviously still very low, and do not provide enough interest income for most long-term investors, which in turn forces them to look for other sources of investment return to meet their goals.

In discussing the recent rise in interest rates, the financial media point to a variety of factors: (A) the growing likelihood of another substantial COVID financial relief package from Congress, designed to stimulate the economy; and (B) the financial market’s anticipation of an improving economy, based on the increasing number of people receiving the vaccination against the virus. Even if these factors prove correct in improving the economy, the Federal Reserve has indicated its desire to keep rates low, focusing on improving the employment situation and not being overly concerned about rising budget deficits. The real fear of bond investors is that an economy that grows too strongly has the potential of bringing about a re-emergence of harmful inflation, which makes the value/purchasing power of money received some number of years in the future lower than anticipated. Typically, when an economy has slack, as the US economy does now, growth can occur with inflation remaining subdued.

As with all forward-looking concepts, the outcome of the interplay among the benefits of the vaccine, a stronger economy, a rising budget deficit, Fed interest rate policy, and possible inflation is unknown. Even if we knew the outcome, we are also aware that financial markets act in strangely contrarian ways at certain times (e.g., extensive stock price gains while the Coronavirus continues strong). As always, we suggest maintaining your previously established asset allocations, without trying to guess which assets will outperform others in a given time frame.