A Coiled Spring?

Given the rapid upward trajectory of the stock market since the March 2020 lows, recent market behavior has felt a little like a wet blanket. The headline S&P 500 index has continued to push higher, and the large-cap tech index Nasdaq 100 has followed along. But for those seeking equity allocation away from large-cap US stocks the returns have been much more challenging.

The small-cap Russell 2000 started to top out in mid-February, while emerging markets topped out a month later. Since Valentine’s Day, the Russell is down a little over 2%, while the S&P has climbed over 12%. Since mid-March, VWO, the Vanguard emerging market ETF, is down over 8%. None of these moves signal a broad-based bull market like 2020.

Currently, many of the analysts for the biggest banks on Wall Street are calling for a 4^th quarter market correction of roughly 10%. Many of these same analysts only see this correction as a stumbling block on the way to still higher markets. It is easy to see why most believe a correction is overdue. We are currently in one of the longest stretches without a significant pullback in the post-WWII era. I also see how analysts believe that the next pullback will be a buying opportunity. Given the length of time since a significant market decline, it is a safe assumption that many investors, with cash on the sidelines, will take that opportunity to buy.

But still the questions over valuations remain. How can they possibly go away? Valuation metrics such as the CAPE Shiller P/E and “Buffet Index” (Market Cap/GDP) are at levels either not seen since 2000 or never seen before. A 10% correction may lure in some investors, but can value investors really pile in simply on the back of a standard correction?

Conversely, many analysts are undeterred by valuations as they see high valuations as a simple by product of historically low interest rates. It is hard to discount this rationale. If high valuations are simply a greater willingness to pay for earnings further out in the future, it seems reasonable that low rates would be a catalyst for high valuations. This reasoning keeps one constantly on edge for signs that rates will start to rise. Which creates an interesting scenario should the Democrats pass the massive spending bill currently in the Senate. One the one hand, deep government deficits seem to force the Fed to keep rates low to finance them. While on the other hand, should the government commit to spending upwards of $4.5 trillion it is hard to see how already rising inflation doesn’t spiral out of control. In this scenario, try as the Fed may, longer term rates will have to go higher.

If this comes to pass, we may see that while Fed money printing has been positive for asset prices, Congressional spending may only cause consumer prices to rise and asset prices to fall.

Thanks for reading,

Zach and Dave

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