Is This Market a Chimera?

As we head into the second quarter of 2021, the US Stock Markets Indices are near their all-time highs.

Many ask, “How can these markets keep propelling higher when so much of the world is in disarray?”

Many market pundits extol the efficiencies garnered in the workplace due to the pandemic, medical breakthroughs and improving employment as signals that the markets can continue their rise. Others caution that several years worth of earnings have been pulled forward in high multiple technology companies which investors gorged themselves on in 2020- feeling a reckoning is just around the corner. As this missive is being written, the Nasdaq has dropped 10% from it’s recent peak, going negative for 2021.

Incongruous though it may appear, good things are bound to come out of this pandemic. Biomedical technologies are likely to enjoy quantum advances. Economists at Vanguard compare the exponential rate of innovation today in biomedicine to the huge leap forward that information technology saw in the 1990s. Others believe the Moderna breakthrough vaccine could soon be applied to treating cancer.

Part of the euphoria is rooted in the expectation of a strong economic rebound as the pandemic fades in the second half of the year. Many economists see GDP in the U.S. rising between 4.5% and 5.5% for the year. The United States economy hasn’t achieved an above 3% rate of growth since 2006.

Many Americans have saved a substantial cache of money and can’t wait to return to normalcy. That’s the new Roaring Twenties scenario pervading current stock market psychology. Some bulls even see the Democratic control of both houses of Congress as a positive sign that further stimulus is on the doorstep as of this writing. While Democrat’s twin Senate victories in Georgia prompted many advisors to prepare their clients for higher taxes, the stock market celebrated the prospect of higher interest rates by sending bank stocks surging.

A Dose Of Reality

How much of this optimism is just fantasy remains to be revealed. Will the markets give ground and reset lower to correct these expanded multiples? Perhaps they are priced to perfection? This is the eternal question facing every investor.

Due to the Covid-19 disruption, it has been forgotten that corporate profit margins were falling, GDP growth was subpar, and companies were overly reliant on financial engineering to beat their earnings estimates due to the prior administration’s massive tax cut for corporations.

There are a lot of large, public, U.S. businesses with 7% operating profit margins masquerading as entities with 11% margins. Some companies looking for growth are entering new industries. Apple, for example, is going into the automobile business. Bold, outside-the-box moves like that rarely expand margins near term.

There is a deep concern that temporary layoffs could become permanent. Even before the pandemic, one of the biggest fears among labor economists was that artificial intelligence and robotics would result in the elimination of more than 20 million jobs over the next two decades. By all accounts, Covid-19 has accelerated the journey to a digital future.

Contrarian Views

Current high prices are masking the violent rotation between the “haves” and the “have nots” of 2020. Information technology was up 43.9% while energy fell 33.7%. A violent rise (read: selling of bonds) in interest rates is recalibrating the technology sector’s earning’s multiple while giving lift to cyclical stocks. For example, profit starved companies such as Southwest Airlines, Caterpillar and Macy’s hope for expanded economic activity in travel, infrastructure, and retail spending.

It’s a major issue for vulnerable long-duration assets, like technology companies and venture capital-backed businesses, not to mention long-term bonds. Shares of energy companies, retailers, banks, chemical concerns and companies in a host of other industries are hardly in bubble territory.

Over the last five or six years, the earnings of many health-care companies have climbed at almost the same rate as technology concerns, but the former group has seen virtually no multiple expansion. Usually, Big Pharma is a whipping boy for politicians of all stripes, but the pandemic has quieted many of the critics. People are willing to pay for drugs that are truly innovating.

Going Global

This may be a time for better bargains existing beyond U.S. borders. American stocks have deserved a premium because they are composed of more asset-light businesses with high-value intellectual property—but investors have been rewarding them for more than a decade.

Many American investors may barely have noticed, but emerging markets have been on a roll for the last two years. The MSCI Emerging Markets Index climbed 18.4% in 2019 and 18.3% in 2020.

At the depths of the financial crisis in 2008, few were saying emerging markets would emerge unscathed. The consensus was that they needed developed markets to sell their goods and commodities to. In fact, they came back from the crisis faster than other markets, advancing 78.5% in 2009, led by a China induced infrastructure boom.

Not all past experiences match exactly but that scenario is possible, especially due to a much lower price to earnings multiple. Currently worries center on their inadequate health-care systems. Emerging markets may suffer more human damage but less economic damage. Abroad, they are far more accustomed to crises like the pandemic because they happen much more often in less developed countries. For better or worse to their population, this is capitalism doing what it is supposed to do. Powering through issues even though many of the emerging countries are not democracies.

The U.S. dollar has been softening for most of the last year, and the trade deficit is bulging. It well may be that the 11-year bull market run has left American investors “geographically myopic”, sitting on one side of the boat. Returns outside the U.S. could be substantially better.

If non-U.S. investing stages a comeback and money continues flowing out of America, a lot of people could find themselves on the wrong side of the boat, in other words a painful Chimera.