After watching the catastrophe at the U.S. Capitol building last week, it’s clear to me that we ain’t normal. But that’s not the only way to measure our lack of normalness.
According to the CNN Business “Back-to-Normal” index, we ain’t normal. The Back-to-Normal index represents how close the U.S. economy is to returning to its pre-pandemic level. As I write this column, the index tells us that the economy is operating at 75 percent of where it was in early March 2020. The index was hovering around 83 percent for most of October 2020. Since then, it has been trending downward.
Fortunately, due to the recently passed $908 billion COVID-19 relief package, the economy should avoid an outright double-dip recession. However, it does still feel like a recession. A recent survey of businesses by Moody’s found that not a single respondent thought that current conditions are improving. Moody’s noted that typically, when less than one-fifth of respondents say that current conditions are improving, the economy is in a recession. That is in contrast with the Atlanta Fed’s GDPNow estimate of a whopping 8.9 percent growth of Gross Domestic Product (GDP) for the fourth quarter of 2020.
Of course, the fourth quarter is history. When it comes to the economy, the stock market wants to know, “what have you done for me lately?” And that’s not all it wants to know. I don’t mean to suggest that the stock market is always correlated to the economy. On April 29, 2020, I wrote a column titled “It doesn’t make sense,” which highlighted the disconnect between a rising stock market and a struggling economy.
Now, conversely, as the economy is improving, I suspect that the stock market will correct — maybe even experience a mini-crash. That would be painful but helpful, as the market needs to work off some of the excess froth built into some inflated stock prices.
The U.S. economy may stay below its pre-pandemic level for a while, but I suspect it will continue improving. That continuous improvement should support the market after any significant drawdown in prices. A correction should be a buying (or rebalancing) opportunity, instead of a reason to proactively get more defensive.
While I am concerned about the stock market for the months ahead, an end to the pandemic will support stock prices beyond any short-term adjustments. According to the Centers for Disease Control and Prevention (CDC), more than 17 million COVID-19 doses have been distributed. Nearly 5 million people have received their first of two necessary doses. That is well below the goal of President Trump’s Operation Warp Speed program. However, logistics are starting to fall into place.
In an interview on ABC News on Sunday, Jan. 3, Dr. Anthony Fauci, director of the National Institute of Allergy and Infectious Diseases, explained that the U.S. could achieve a pace of one million inoculations per day.
The expectation of one million inoculations per day is consistent with what is becoming a consensus. The Biden administration is expected to take a more active role in managing state and local vaccination efforts, hopefully getting the U.S. to that pace sometime this spring. After a couple hundred million inoculations, I expect the U.S. economy to pick up considerable steam over a couple of years. There is pent-up demand for consumer services, such as personal care, recreation, transportation, restaurants, hotels, and elective healthcare. That pent-up demand may not be unleashed all at once, as there will not be a light that goes off to let us know when the pandemic is officially over. But that demand will manifest in economic activity. It will be sustained, and it will fuel the growth of the U.S. economy and, I suspect, stock prices.
The yield of the 10-year Treasury note topped 1 percent last week for the first time since March 2020. The yield increased amid the Georgia runoff elections, as two Democratic senators were voted into office. The higher interest rate reflected that additional economic stimulus would more easily be passed under a 50/50 Senate, with the tie-splitting vote going to Vice President Kamala Harris. Consideration of higher tax rates stifling the economy was shelved. It is expected that President Biden would be prudent and not raise taxes until the U.S. economy and the unemployment rate approach pre-pandemic levels.
The note’s yield is typically reflective of expected inflation, the level of short-term rates set by the Federal Open Market Committee, and the term premium. The term premium is the (usually) extra yield an investor requires to hold a bond for a longer time.
The rise of the 10-year’s yield was in reaction to higher expected inflation, which would theoretically be caused by more robust economic growth due to extra stimulus. The yield could rise even higher for another reason. The larger deficit will likely require the Treasury Department to issue even more bonds, presumably at more attractive (i.e., higher) yields.
One of the seemingly acceptable narratives about why the stock market should be enjoying high valuations is its relatively low interest rates. I agree with that, to some extent. But you can’t, on the one hand, say that lower interest rates are good for the stock market, then, on the other hand, say that higher interest rates should be ignored.
When it comes to interest rates, you are not allowed to have your cake and eat it, too. That was certainly the case in late 2018, when an improving economy helped push the yield of the 10-year Treasury note above 3 percent. Interest rates at that level helped triggered a roughly 20 percent stock market crash.
Blue Wave stock selection
For now, the yield of the 10-year Treasury note is in a sweet spot for the economy. Higher long-term interest rates are a much-needed shot in the arm for financial stocks. All other things equal, banks make more money when the yield curve steepens (the short end of the curve stays low as the longer end rises). As recently as January 6, 2020, the Fed reminded us, via the minutes of their December 15-16 FOMC meeting, that they intend to keep short-term rates low for a considerable period. The Fed also reiterated that they would give the public plenty of notice on any decisions that could raise short-term rates. After a long period of underperforming the general market, higher interest rates relative to low-interest rates makes financial stocks attractive.
Speaking of all things relative, according to Fundstrat Global Advisors, of the $3.1 trillion of retail inflows into financial assets since 2008, 94 percent went into bonds. Not stocks, but bonds. While I am not comfortable with stock market valuations, retail inflows suggest that between the two, if there is a bubble, it’s in bonds and not stocks. I am dreading the next stock market correction because I fear it could be a big one.
As I’ve said before, I wouldn’t try to be proactive and raise cash in an attempt to avoid a correction. Instead, I suggest that you consider being reactive during a correction by switching some of your large-cap positions to small-cap stocks. I already hold small-caps, and I am considering holding more — even before a reactive switch. The earnings of small capitalization companies tend to be more economically sensitive to faster GDP growth, which is expected following the “blue wave.”
On September 30, 2020, I wrote a column detailing how the economy would fare under different electoral outcomes. That included the economic forecast following a so-called “blue wave”— a Democratic White House and a Democratic Congress.
In that column, it was determined that a blue wave would be the best possible electoral outcome for the years ahead. I wrote that “Biden proposes to spend $7.3 billion over the next decade. It would be a challenge for the economy to not be stimulated by such an aggressive spending campaign. The estimate is for the creation of 18.6 million jobs in Biden’s first term, with the economy reaching full employment (just over 4 percent) by the second half of 2022.” I provided the below table for that column:
Average annual growth
2020 2021 2022 2023 2024 2020-2024 2020-2030
(percent change) -4.9 4.2 7.7 3.2 1.8 4.2 4.2
Corporate Profits -11.3 17.6 9.7 4.3 3.2 8.6 8.6
The Georgia Senate results should add some “oomph” to the stock market, even after the next correction. The election sparked hope for additional stimulus, which revives the so-called reflation trade. Also, there is now a greater expectation of passing a spending bill to support infrastructure repair. That should be a tailwind for stock prices of companies in the industrials and materials sectors.
This article originally appeared in The Berkshire Edge on January 11, 2021.