Reality Vs. Illusion – Unmasking The Financial Market
The artist René Magritte once stated, “Everything that is visible hides something that is invisible.” As a money manager, one is always looking at any number of market indicators to determine where we stand and where we may be headed in the financial markets. As always, trying to unpeel the “visible” indicators can lead to different interpretations. However, today’s market also reveals an extreme level of manipulation. For example, looking at US treasury yields as an indicator seems fruitless as the Federal Reserve is now controlling the yield curve. Even the MOVE index (an index measuring bond market volatility), which is now below pre-Covid levels, is effectively useless as the Fed has pumped so much liquidity into the bond market.
On the other hand, if you look at the VIX (a gauge for stock market volatility), the index remains elevated. Also, the CLO (collateralized loan obligation) market has seen defaults escalate, as these markets have been unmanipulated by the central banks. Finally, the vast foreign exchange markets have put downward pressure on the US dollar, which has declined to the lows experienced in March when all markets were coming apart — suggesting to me that we are undergoing a shift to a weak US dollar environment. All these factors warrant a continued level of market caution particularly since a handful of the largest U.S. tech stocks (i.e., FAANG, tech-monopolies) have propelled the supposed stock market recovery since March. When I think about the Nasdaq NDAQ today, we could point to Japanese bank stocks in the late 1980s. At the peak in 1989 the capitalization of the broad Topix represented more than 50% of the entire world’s market cap, and Japanese banks’ shares by themselves made up half the Topix by capitalization. Therefore, at their height, Japanese bank shares made up 25% of the world market cap! Guess how things ended? Even thirty years later, they are an inconsequential fraction of the world’s aggregate equity market. Today, the market value of the Nasdaq is greater than the MSCI World (ex US) market cap. Hmmm?
Frankly, this group of stocks reminds me most of the “Nifty Fifty”, which were seen as ‘one decision’ stocks that could do nothing wrong in the early 1970s. Furthermore, they were deemed “scarce” assets and perceived to be the only companies that could grow. As Louis Gave states, excess money pushed valuations of these “scarce” stocks higher “until 1973, when oil prices spiked and all of a sudden investors were forced to reassess what was scarce (oil) and what wasn’t (production capacity).” Today, this new group of large U.S. tech companies may turn out “to be neither very nifty, nor that scarce.”
Similar to the 1970s, we are entering a period of inflation after an extended period of disinflation. Secondly, we have seen gold rally and hit recent new highs although we are still in the early stages of its own bull market. Finally, the Federal Reserve is becoming simply another regulatory agency under the power of the politicians. The politicians are determining how much money is needed for endless stimulus, while the Fed is rendered powerless and forced to hit the print button. As the investor Russell Napier recently mentioned, “It’s ironic that most investors believe in the seemingly unlimited power of today’s central banks. But in fact, they are the least powerful they have ever been since 1977.” By the time the 1970s ended, financial assets were cheap, while real assets were expensive. Today, it’s just the opposite. Back then, we were so upset about inflation that we were willing to endure a recession to fight it. Now, we are so resistant to a recession that we are willing to endure much more inflation. How times have changed.
Already we are seeing signs of inflation from everything to groceries, haircuts, and menu prices at restaurants. Some of the price shift is demand driven, but we are also seeing more scarcity in some areas. For example, just as there was a scarcity of facemasks and toilet paper during the early innings of Covid in March and April, we see many other examples manifesting now across industries. Take for example, aluminum. Brewers have had to scale back production of smaller brands as they face an aluminum can shortage. As we continue to see more and more examples of real scarcity (not perceived scarcity like we see in the valuation of large cap tech stocks), we will experience more and more inflation. Most recently, we saw Warren Buffett purchase an energy infrastructure company. Why? Perhaps he views increased regulation and an inability to build more capacity in the future will make those assets more valuable. I tend to agree. Buy things that are (or may become) scarce, not simply perceived to be so. Owning real assets like energy infrastructure and gold, along with companies with solid balance sheets that sell essential products and services, and maintain a healthy chunk of liquidity are important in the current investment environment. As the French historian René Girard once said, “The revelry is always over some scarce object, it is acquisitive mimesis, the desire for something scarce.”