Equities

Overconcentration of returns in a handful of stocks has been an overarching theme in a number of our 2020 publications. For instance, we separated the SPX in the S&P 5 vs. the S&P 495 in late-July, and showed how a handful of tech titan stocks dominated S&P 500 returns, especially since 2015. Roughly a month later these tech stocks peaked, and the normalization process began (top panel). It is remarkable that the S&P 5 are down in absolute terms since their September 2 crest, whereas the S&P 495 are up over 15%. The recent surge in the 10-year Treasury yield exacerbated the nosedive in relative share prices as it deals a blow to the bubbly valuation of the longest duration sector in the SPX: the tech sector. Crudely put, the steeper the selloff in the bond market the greater the fall in relative market capitalization (10-year Treasury yield shown inverted, middle & bottom panels). Bottom Line: Stick with a barbell tech sub-group positioning, preferring software and services to hardware and equipment, but stay tuned.  

Special Report

Highlights Strong/weak productivity growth leads to secular bull/bear markets in both equities and the currency. We illustrate why and how robust productivity gains can engender a virtuous self-reinforcing cycle that can run for many years. Detecting productivity for macro strategists is akin to doctors diagnosing a patient – it entails more art than science. Inflation, the real trade balance, and company profit margins constitute a litmus test for assessing productivity growth. Feature By far, the most critical variable determining long-term economic growth is a country’s productivity. This report presents why productivity matters for investors and examines how to gauge productivity growth given it is practically impossible to measure accurately. We use the framework presented in this report to analyze long-term trends in individual EM economies. In a follow-up piece, we will present a practical application of this framework by ranking developing economies according to their productivity and long-term growth potential. This report does not discuss what is needed to boost productivity because the policy prescriptions are well known and are widely available in economic literature. That said, we have outlined some of these in Box 1. BOX 1 The Basic Formula For Long-Term Growth For any economy, the potential growth rate is what can be achieved and sustained in the very long run. It can be expressed as follows: Potential (real) growth rate = productivity growth + labor force growth Given that we can use demographic data to approximate the number of people entering and exiting the labor force for each year over the next 18 years, the labor force growth variable can be easily estimated. Hence, the key unknown in the above formula is productivity growth. In a developing economy, it is difficult to measure productivity accurately (Chart 1). That is why when analyzing the long-term outlook, we first assess whether the country has effectively implemented the structural reforms needed to achieve faster productivity growth – some of which are listed below. We combine these observations with symptoms associated with either strong or weak productivity growth in order to assess an economy’s potential growth trajectory. Chart 1Productivity Growth Estimates For EM/China Recommended policies to raise productivity growth typically include: building hard and soft infrastructure, improving education and training, investing in new technologies and equipment, promoting entrepreneurship and formation of new businesses, promoting competition, augmenting R&D spending, importing foreign “know how,” and fostering industry clusters that specialize in certain products or processes. Why Does Productivity Matter For Investors? Following are the investment implications of productivity growth: 1. Productivity is the sole driver of growing prosperity, which is reflected in rising per capita real incomes (Chart 2). Productivity = output per employee per hour  = (real GDP or output) / (number of employees x number of hours worked) Rising productivity creates more income that is shared between employees and shareholders. If productivity rises by 5% and hourly wages increase by 2.5% in a year, unit labor costs will drop by 2.5%. In such a case, the 5% increase in productivity is shared equally between shareholders and employees. A lack of productivity gains and resulting stagnant income for both employees and business owners might lead to rising socio-political tensions and ultimately to political instability. 2. Strong productivity gains allow an economy to grow faster without experiencing high inflation (Chart 3). The upshot is reduced cyclicality in economic activity, i.e., business cycles are characterized by longer expansions and shallow and less frequent downturns. Equity investors will thus likely pay higher equity multiples due to the reduced cyclicality of corporate profits. Chart 2Productivity Is Ultimately Reflected In Rising Real Income Per Capita Chart 3China: Strong Productivity Growth Has Kept A Lid On Inflation   The rationale is that robust productivity advances allow the economy to expand with low inflation with no need for monetary tightening. The relationship between productivity and inflation is discussed in detail below. A structurally low inflation environment allows policymakers to promptly deploy large monetary and fiscal stimulus when faced with economic downturns. In addition, low interest rates are also associated with higher equity valuations. On the contrary, a lack of productivity growth makes business cycles short-lived. Inflation will rise faster during a business cycle expansion in an economy with low productivity growth. In turn, interest rates will rise more rapidly in those economies, short-circuiting the expansion. Equity investors will be reluctant to pay high multiples for companies operating in such environments. 3. On a microeconomic level, high productivity gains are typically associated with higher profit margins and vice versa (Chart 4). Shareholders assign higher equity multiples to enterprises with higher profit margins and return on capital. Chart 4Faster Productivity Growth = Wider Corporate Profit Margins Besides, wider profit margins allow companies to tolerate higher real interest rates. High real interest rates attract foreign fixed-income capital supporting the nation’s exchange rate. Given that labor costs make up a large share of costs in many companies, unit labor costs are a critical determinant of corporate profitability. Meanwhile, selling prices, sales as well as input prices are often beyond management control. Therefore, raising productivity (output per hour of an employee) is one of the few ways to lift corporate profitability and, by extension, return on capital. Unit labor costs = (wage per person per hour) / productivity 4. Rapid productivity advances allow companies to become more competitive without currency depreciation (Chart 5and Chart 6). Exchange rates of countries that achieve faster productivity growth typically appreciate in the long run. Chart 5Switzerland: High Productivity Has Sustained Competitiveness/Export Volumes Despite Currency Appreciation Chart 6China and Vietnam: Rising Export Market Share Reflects Productivity Gains   Enterprises with higher productivity can drop their selling prices with limited impact on their profitability. By doing so, they can undercut their competitors and gain market share. Hence, solid productivity gains also entail a competitive currency, eliminating the need for central banks to hike interest rates in order to defend the exchange rate. 5. High indebtedness – in both public and private sectors – is easier to manage amid brisk productivity gains because the latter generate strong economic growth and relatively low nominal interest rates. Robust income gains among businesses and households, as well as for the government via taxation, enable indebted agents to service higher debt loads. Besides, nominal GDP growth above nominal interest rates arithmetically implies a drop in the public debt-to-GDP ratio. In brief, the economy could “grow into its debt” with robust productivity gains. In sum, strong/weak productivity growth leads to secular bull/bear markets in both equities and the currency. Rapid Productivity Gains Lead To A Virtuous Circle The following illustrates how robust productivity gains can engender a virtuous self-reinforcing cycle that can run for many years. Fast productivity gains allow for either fast wage or rapid corporate profit growth or a combination of the two. As income per capita rises, consumer spending grows and capital owners are willing to invest. New investments create new jobs and income and could also boost future productivity if substantial capital misallocation is dodged. The economy expands at a rapid rate, but inflation and, thereby, interest rates remain capped because the economy’s productive capacity grows in line with demand. Strong income and profit growth as well as stable borrowing costs lead to more credit demand from both households and businesses. Bank and non-bank credit expand but rapid household income gains and healthy enterprise profitability as well as growing government tax revenues support the private or public sectors’ debt servicing capacity. Robust economic growth, elevated real interest rates and high profitability attract foreign capital and foreign inflows lead to currency appreciation. Yet, such currency appreciation should not undermine the competitiveness of local producers – both exporters and those competing with imported goods. As discussed above, sizable productivity gains could reduce unit labor costs and allow domestic companies to drop their prices, sustaining their market shares in both export markets and domestically. Consequently, the trade balance does not deteriorate structurally despite a rapid expansion in domestic demand. Healthy balance of payments support the currency, i.e., the central bank does not need to hike interest rates or draw down reserves to defend the exchange rate. Finally, rapid corporate profit and household income growth as well as reasonably low nominal interest rates sustain high asset (equity and property) valuations for longer. Such a virtuous circle can persist until something breaks or major excesses – for example, capital misallocation, credit or property bubbles – emerge and then unravel. Meager Productivity Gains Lead To A Vicious Circle The following demonstrates how stagnant productivity can set in motion a vicious self-reinforcing circle. With no productivity gains, a business cycle recovery will likely lead to higher inflation sooner than later. The latter will short circuit the economic expansion as the central bank is forced to hike interest rates. If the central bank does not hike interest rates despite rising inflation, real (inflation-adjusted) interest rates will fall and could become negative. Low real rates are bearish for the currency. Either the central bank will be forced eventually to hike interest rates substantially or the exchange rate will continue depreciating. There are two reasons why low real interest rates are negative for the exchange rate: (1) low real borrowing costs will encourage more borrowing, spending, and investment. Such very strong domestic demand in the context of limited domestic productive capacity will lead to a ballooning trade deficit; and/or (2) low real interest rates will discourage foreign fixed-income capital inflows and weigh on the currency. With no productivity gains, any increase in wages will lead to rising unit labor costs and shrinking profit margins; corporate profitability and return on capital will plunge. The sole way to protect profitability amid rising unit labor costs is to raise selling prices. The latter could spur a wage-inflation spiral. Rising unit labor costs and resulting shrinking corporate profit margins leave domestic producers no room to reduce their selling prices to compete in export markets and with imports. The result is less exports, less import substitution and a deteriorating trade balance. In such a case, the only way to restore the competitiveness of domestic producers is to devalue the exchange rate. Declining or low returns on capital will discourage business investment, in general, and foreign direct investment (FDI) in particular with negative ramifications for future productivity. A worsening trade balance as well as diminishing foreign equity and FDI inflows also entail currency depreciation. This feeds into inflation and leads inevitably to monetary policy tightening. Such tightening prompts weaker growth, lower profitability and more foreign capital outflows. This vicious circle can persist until a major regime shift occurs: a dramatically devalued currency that stays very cheap or corporate restructuring and structural reforms that lead to higher productivity. Commodity Prices And Productivity A critical question to address regarding productivity in commodity producing countries is the issue of rising and falling commodity prices. Higher commodity prices lead to improved prosperity and vice versa. Does this mean that high commodity prices should be treated as productivity improvements? There is some ambiguity in regard to this but our preference is not to treat fluctuations in commodity prices as changes in the nation’s structural productivity. Let us consider the examples of Nigeria, which produces and exports oil, and Vietnam, which manufactures and ships smartphones in large quantities. Let us assume that smartphone exports are as important to Vietnam in generating income per capita as oil exports are to Nigeria. A doubling in oil prices amid flat oil export volumes would generate windfall oil revenues which would lift Nigeria’s income per capita. If smartphone prices remain constant but smartphone production and shipments (volumes) double, income per capita in Vietnam would rise as much as in Nigeria.1   The difference between these two scenarios in Nigeria and Vietnam is as follows: Nigeria would be made richer due to the price increases: it would be producing and exporting the same number of barrels of oil but a doubling in crude prices would augment income per capita in Nigeria. The problem is that Nigeria does not control oil prices. If oil prices decline, the nation’s income per capita would also drop substantially. Hence, there would have been no genuine (structural) productivity gains and Nigeria’s prosperity would be at the mercy of the global oil market. In the case of Vietnam, its productivity will have risen as it has succeeded in producing twice as many smartphones as it did last year. The country has built capacity, acquired technology and developed human skills to double smartphone production. This increased capacity, technology acquisition and skills cannot be taken away from Vietnam. This is a case of genuine productivity advancement. In fact, Vietnam could build on these skills and start producing other, more value-added goods. What if Nigeria doubled its oil output and export volume due to more investment and new technologies (as the US succeeded in doing with shale oil)? This scenario would qualify as genuine productivity gains. At any oil price scenario, Nigeria’s oil export revenues would double. The sole caveat is that the new oil production should have reasonably low breakevens, i.e., oil production should be viable even if oil prices decline. The same caveat is applicable to Vietnam. The difference between Nigeria (oil) and Vietnam (smartphones) is that commodities prices are much more volatile than manufactured goods prices. Bottom Line: In commodity producing countries, rising commodities prices have the same effect on income per capita as productivity gains. However, per capita income gains originating from higher commodities prices are reversable, i.e., not sustainable in the very long run. Consequently, higher commodity prices should not be treated as structural productivity gains. By contrast, productivity advancements – like Vietnam doubling its capacity to produce smartphones or Nigeria doubling its oil production volume – are non-reversable, i.e., they cannot be taken away. Hence, these constitute genuine productivity gains. Detecting Productivity Is Akin To Doctors Diagnosing A Patient Even in advanced countries, productivity is hard to measure accurately. Hence, any measure of productivity in developing economies should be used with a grain of salt.  How do we carry out long-term analysis of developing economies when the key variable – productivity growth – is hard to measure? How do we make projections about productivity growth going forward? We see structural macro analysis as analogous to the work of doctors. When diagnosing a patient, doctors cannot necessarily observe what is happening in the patient’s body. Doctors conduct various tests and then analyze those results in the context of the symptoms. Putting it all together, they make a diagnosis and prescribe the necessary treatment. Similar to the manner in which doctors rely on symptoms and medical tests to determine where there is sufficient evidence of a disease, macro strategists do not see what is really occurring in their “patient’s” body, i.e., economies. Data for macro strategists is akin to medical tests for doctors. In developing countries, the quantity of economic data available to macro strategists is limited and of poor quality. Therefore, observing symptoms of economies under consideration and interpreting them correctly is crucial to the job of macro strategists for emerging economies. As they can count less on hard data and instead rely more on symptoms, their analysis is more of an art than a science. Symptoms Associated With Productivity: How To Detect Productivity At a country level, robust productivity gains are ceteris paribus typically associated with: A structurally improving real trade balance (exports minus import volumes), which is not due to a cheapened currency or a relapse in domestic demand but is due to domestic producers achieving the following: Becoming more competitive and gaining market share in global trade Succeeding in import substitution (imported products are crowded out by locally produced ones) Low inflation during an extended period of business cycle expansion Corporate profit margins expanding simultaneously with higher wages amid low inflation. A lack of productivity gains are ceteris paribus normally attendant with: A structurally deteriorating real trade balance as: Domestic producers lose market share in global exports Domestic producers lose market share to importers in local markets Rising inflation amid a moderate recovery in domestic demand Lingering downward pressure on corporate profit margins i.e., a modest rise in wage growth leads to a drop in corporate profit margins. On the whole, inflation, the real trade balance, and company profit margins constitute a litmus test for assessing productivity growth. A widening real trade deficit is a form of hidden inflationary pressure and a sign of lackluster productivity growth. The rationale is as follows: In a closed economy, when expanding demand outpaces the productive capacity of that economy, i.e., productivity gains do not keep up with thriving domestic demand, inflation will rise considerably. In short, rising inflation will be a symptom of paltry productivity gains. In an open economy, when domestic demand outpaces the productive capacity of that economy, inflation might not rise as demand could be satisfied by imports of foreign goods and services. In such a scenario, even though the trade balance will deteriorate, the currency might stay firm for a while because of foreign capital inflows or rising export (commodities) prices. As a result, inflation will stay low for some time. Eventually, when tailwinds from foreign capital inflows or high export prices cease, the currency will nosedive. Importers will have to raise prices in local currency causing a spike in inflation. Why would foreign capital inflows halt? Lackluster productivity gains amidst solid wage increases would cause a corporate profit margin squeeze and profitability will plummet. As a result, both FDI and equity inflows will dry up and the currency will depreciate. The latter will push up inflation considerably. In a nutshell, in an open economy poor productivity growth might not necessarily lead to high inflation where domestic demand can be satisfied by imports. In these cases, we can say that a widening real trade deficit is a form of hidden inflation. The only exception is when the real trade balance deteriorates due to imports of capital goods and/or new technologies that will be used to build new productive capacity. In such a case, a ballooning trade deficit should not be viewed as a form of hidden inflation and poor productivity growth. If consumer goods dominate imports, this would signify low chances of sizable productivity gains in a given country. If capital goods dominate imports, there are higher odds of future productivity gains. If these imported equipment and technologies are properly utilized, they will make the nation productive and competitive in the coming years. Higher productivity stemming from imports of these capital goods/new technologies, i.e., enlarged capacity to produce goods and services at lower costs, will cap inflation as well as expand exports and result in significant import substitution. A Checklist For Detecting Productivity Diagram 1 presents macro signposts that can be used to diagnose whether an economy is experiencing strong or weak productivity growth (these do not include traditional metrices such as education, R&D spending, strong governance, soft- and hard-infrastructure, etc.): Diagram 1A Checklist For Detecting Productivity Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1  We assume here that all inputs for smartphones are produced domestically, in Vietnam. This is not a realistic assumption, but we use it only to illustrate a macro point about productivity.

​​​​​​​Consistent with the previous Insight’s cautionary tone, we recommend investors book gains of 16% on the small size bias that we have been exploring since the October 26, 2020 inception (top panel) and 6% since the high-conviction calls report on December 7, 2020. Small caps have gone parabolic since late October and the small/large 13-week rate of change annualized momentum is at the highest print since the dotcom bubble era breaching 100%/annum recently (second panel), and second largest ever in the history of our data set (not shown). The top 10 constituents of small cap indexes are now populated by highly speculative names (see here and here) and in the Russell 2000 specifically the weights of some of the top 10 constituents have jumped to more than 10 fold from the 0.05% median weight to over 0.5% weight. In other words, elements of frothiness are also evident in small cap indexes. At least a pause for breath is likely in the next three months and we opt to move to the sidelines and downgrade the size bias back down to neutral. Finally, we are also shifting the 10% stop in our long “Back-To Work”/short “COVID-19 Winners” pair trade baskets to a 5% rolling stop in order to protect gains of over 25% since the September 8, 2020 inception (bottom panel). Bottom Line: The easy money has been made in the small/large ratio, lock in gains and step aside. Today we also switch our trailing 10% stop to a rolling 5% stop in the long “Back-To Work”/short “COVID-19 Winners” pair trade baskets. Stay tuned.

The previous Insight highlighted the similarities between the 2009/10 episode and today, when the SPX troughed in March 2009 similar to the recent recessionary trough in March 2020. Our biggest worry is the reflex rebound in the dollar. Everyone is short dollars and this one-sided bet is at risk of capsizing the ship. Importantly, interest rate differentials will likely start to push the greenback higher. The bottom panel of the chart shows that since the August trough, 10-year US Treasury yields have more than doubled to over 1.1%, whereas the 10-year bund yield has stayed muted at -0.5%. Additional US fiscal easing along with the sustained rebound in the US economy should continue to weigh on bond prices and further push interest rates higher and eventually stock valuations lower. This accumulated interest rate pressure will at the margin start to weigh on EUR / USD. As a result, the near parabolic move in cyclicals versus defensives will at least go on hiatus. We are putting the S&P utilities sector on upgrade alert and the S&P materials sector on downgrade alert and once we execute these moves our portfolio will hopefully monetize double digit gains since the July 27, 2020 inception, and will push our cyclicals/defensives portfolio bent back to even keel. Bottom Line: Prepare to lock in gains in the cyclicals versus defensives portfolio bent (via downgrading materials and upgrading utilities), this ratio is now on our downgrade watch list (please see the next Insight).  

Last autumn during the 10% SPX correction, we started to reposition the portfolio to benefit from the reopening trade and initiated our long “Back-To-Work”/short “COVID-19 Winners” trade, implemented a small cap size bias, reiterated our cyclicals / defensives portfolio bent by downgrading the S&P pharma index to underweight (which pushed the S&P health care to neutral) and crystalized handsome gains in our VIX futures trade. We were arguing that stocks would glide lower into the election and then take off as geopolitical in general and election in particular uncertainty would subside and also seasonality would switch from a headwind to a powerful tailwind for stocks. One week following the election we updated our three EPS scenarios for 2021 and also upped our calendar 2021 EPS estimate to $168, from $162 previously, and lifted our SPX target for end-2021 to 4,000. Since then, the SPX is up nearly 600 points and we are now compelled to turn wary. Keep in mind that the S&P 500 has fully discounted the 24% EPS growth for calendar 2021 and now that we are in early 2021 and the market will soon look into calendar 2022 EPS, we doubt that the sell side’s $196 EPS level which translates into 17% EPS growth rate is attainable, especially given the specter of rising corporate taxes.     The higher the SPX will rise in the near-term the more it will eat into future returns and thus push down the expected return. Equity flows are very powerful both from sidelined cash coffers, which are getting replenished from fiscal easing packages and from investors fleeing bonds. The implication is that timing the exact turn is difficult. The chart (on the previous page) shows that 2009/10 is an interesting parallel to draw, which we used recently when we initiated a VIX futures hedge to our high-conviction calls for the June 2021 expiry, as a number of asset classes signal that it is prudent to be cautious especially on the prospects of the broad equity market. Applying the SPX return from the 2009 trough to the 2010 peak, implies that the SPX can rise to 4,010 if history at least rhymes. Given recent bubble talk in the media, using the October 1998 to March 2000 parallel and applying that SPX return would imply an SPX level of 3,687 (see table). Our sense is that the further we rise the bigger the snapback will be and a retest of the October 2020 lows is a high probability event. Thus, from a tactical perspective we are not willing to risk 100-200 points of upside for a potential 800-point drawdown. One enticing synthetic long trade recommendation we are initiating is to buy a $390/$410 call spread on the SPY ETF and sell a $340 put for March 19 expiry for a modest cost of $0.67 per contract. The June expiry is a good alternative for more conservative investors with an actual $2.85 per contract cash inflow. This is not a speculative trade; it is a way to deploy fresh capital (i.e. covered position) at a much lower S&P 500 level given our still sanguine broad equity market view on a cyclical 9-12 month time horizon. This way we can partially participate (as we cap our gains) in the unfolding mania, and if markets turn around, as we expect on a near-term tactical basis, this trade goes long the SPY at a much lower level. Bottom Line: The board equity market risk/reward tradeoff is to the downside for the next three months on a tactical basis (please see the next Insight).

Highlights We remain constructive on the economy and financial markets, … : US households have stored up a great deal of dry powder for consumption once the economy fully reopens, last month’s stopgap fiscal measures will help relieve pressure on the most vulnerable households, and the Georgia Senate results ensure that even more fiscal transfers are in store. … but there is a non-negligible risk that investors will get too excited about the positive backdrop: The exceedingly supportive policy backdrop could easily help the S&P 500 push into the low 4,000s, but it’s not clear what investors will have to look forward to for the rest of 2021 if it ascends to that level early in the year. We do not share the bubble-spotters’ alarm, but we are willing to study their arguments: We like to test our convictions by seeking out opposing views and we therefore read Jeremy Grantham’s bubble essay with great interest. We do not share his urgent concern, and our recommended asset allocations are nearly the mirror image of his, but we are taking a deep dive into his view and its implications. Feature As a grad student on the South Side of Chicago, I used to run on the bike path along the lake. On windless days, the three or four miles north from Hyde Park Boulevard felt especially easy, and I would think, “this is what it’s like when there’s no wind.” Then I’d head for home and discover there’d been a breeze behind me all along. A mile or two in, I’d realize it was no breeze and marvel at how I hadn’t noticed it on the way out. The moral of the story, as I told it then, is that if you think it’s not windy in Chicago, just turn around. Now it seems that it has a broader, weightier lesson: it can be easy to miss the wind when it’s behind you. Jeremy Grantham’s carefully reasoned bubble warning, posted online last Tuesday,1 has inspired us to re-examine our outlook and how widely it’s shared. We are not changing our view – we remain vigilantly bullish – but it is worth devoting ample time to consider the risks to it. This week, we highlight the elements of Grantham’s piece that most caught our attention; next week, we will discuss strategies to try to reduce an investor’s vulnerability to them. The Belated Blue Wave Grantham’s essay highlights vulnerabilities that could come to the fore sometime in the near future, but the Democratic sweep of Georgia’s Senate seats has immediate market implications. By virtue of Vice President-elect Harris’s tie-breaking vote, the Democrats will hold a majority in the 50-50 chamber beginning January 20th. The outcome ensures that the Biden administration will have slim majorities in both houses of Congress for its first two years (pending appointments and special elections). Although a five-seat House majority and the slimmest possible Senate majority will not give the incoming administration carte blanche to enact sweeping legislative changes, it will have an easier time pursuing its agenda than it would have had the Republicans held on to just one of the Georgia Senate seats. Item number one on that agenda is likely to be bulked-up fiscal aid for struggling households, states and municipalities. The economic and market significance of the blue wave is that Congress can now become a full partner supporting the monetary policy aim of erring to the side of providing too much accommodation. With the Fed pledging that it won’t take its foot off the gas any time soon, revived fiscal spending will provide the economy with an incremental reflationary boost that should benefit risk assets. Fiscal transfers will be at least partially funded with increased taxes on corporations and high-earning individuals. Profit margins will narrow, but empirical evidence of a relationship between tax rates and economic growth is elusive (Chart 1). Economic growth is largely a function of growth in the size of the working-age population and growth in productivity. Investment leads productivity – workers become more productive when endowed with more and better tools – but history suggests that investment spending is indifferent to corporate tax rates (Chart 2), as is productivity (Chart 3). Chart 1We Don't Like Taxes, Either ... Chart 2... But They Do Not Seem To Impact Investment ... Chart 3... Or Productivity Growth We are disposed to agree with the idea that higher taxes are a drag on growth. Transferring spending power from the private sector to government apparatchiks is not likely to improve efficiency. Business executives are as fallible as any other experts, however, and changes in tax rates have a smaller multiplier effect than the proposed spending measures. Net-net, we expect that the outcome of the Georgia run-offs will lead to slightly higher interest rates, a steeper yield curve, increased consumption and fewer defaults, a welcome mélange for credit performance and the equities that were left behind as investors flocked to COVID winners. A Slippery Slope Chart 4Bull Markets Tend To Go Out With A Bang [G]reat bubbles are where fortunes are made and lost – and where investors truly prove their mettle. For positioning a portfolio to avoid the worst pain of a major bubble breaking is likely the most difficult part. Every career incentive in the industry and every fault of individual human psychology will work toward sucking investors in. [Emphasis added.] As Jeremy Grantham lays it out, the latter stages of a bull market are especially perilous. Given that bull markets run hot before they end (Chart 4), it becomes fiendishly difficult to resist their pull. The recency bias drives an investor to focus on the most recent data points to the exclusion of older ones, pointing to higher expected returns than might be inferred from a more comprehensive sample. The phenomenon encourages equity overexposure at inopportune times if returns are mean-reverting. Professional investors are as susceptible to recency bias and overconfidence (fueled by having had the wind at their back) as non-professionals, and their judgment can be additionally clouded by career pressures. Those who achieve the longest tenures are at least subconsciously attuned to Keynes’ dictum that it is better to fail conventionally than to succeed unconventionally. Staying at the party too long with lots of others may hold far less risk than staking out a solitary position. The bottom line is that asset management incentives encourage groupthink, especially as late-stage bull markets go into overdrive. Dizzying Heights The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble. Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior, I believe this event will be recorded as one of the great bubbles of financial history[.] Bubbles are only identifiable in retrospect, but several aspects that financial historian Charles Kindleberger associated with manias are evident. Money is cheap and readily available and valuations are quite high. One could argue that anticipation of short-term capital gains is drowning consideration of future earnings for at least some equity investors or, as Grantham puts it, “stocks [are] rising … simply because they are rising.” Make no mistake: Equity valuations are demanding and de-rating appears more likely than continued re-rating. The main valuation metrics clearly indicate that equities are richly priced. The S&P 500’s forward earnings multiple is hovering around two standard deviations above the mean, at heights previously reached only in the late ‘90s and early ‘00s (Chart 5). Price-to-sales is at an all-time high, three standard deviations above the mean (Chart 6, top panel), while book (Chart 6, middle panel) and cash flow multiples (Chart 6, bottom panel) are elevated but not yet extreme. Price-to-sales should rise if markets believe pandemic-induced margin pressure is temporary and will reverse once the country is vaccinated, but the one-plus-sigma surge above pre-COVID levels would seem to be a bit much. Chart 5Equity Valuations Are Pushing The Envelope Chart 6Making A Run At '99-'00 Equity option and IPO activity is redolent of euphoria and overtrading. Equity call option volume has surged to record levels (Chart 7, top panel), reportedly on the back of an explosion in small retail activity, and the put-call ratio has fallen to dot-com-bubble levels as demand for exposure has swamped demand for protection (Chart 7, bottom panel). New IPOs have been coming fast and furious (Chart 8, top panel) at a relatively tender average age (Chart 8, bottom panel). Sponsors’ shift away from hoarding early- and middle-stage returns to inviting the public to share them may prove to be telling. There are many reasons to sell equity interests, but expecting them to blast higher isn’t typically one of them. Chart 7The Merry Men Of Sherwood Forest Have Discovered Options Are A Gas, Too Chart 8Take The Money And Run The Legend Who Cried Wolf This isn’t the first time Grantham or one of his colleagues has expressed concern about rising stock prices. It may be unduly harsh to call him a perma-bear, but GMO has consistently underestimated equities and the firm has seen its assets under management (AUM) cut in half over the last five years, to $60 billion, while its flagship asset allocation fund has lost over 60% of AUM. As an RIA firm executive told a Bloomberg reporter, “I can see how clients lose patience with them. They get defensive way before anybody else.2” It’s important to recognize different commentators’ biases/agendas when evaluating their arguments. Grantham calls out the broker-dealers as perpetual market cheerleaders, but he has a stake in convincing GMO clients and prospects that value investing principles are still relevant. BCA’s business model is far more insulated from markets’ direction, but our research services have a bias to fit inherently unruly markets into tidy narratives. Disclosing the risks to our views is an essential part of our process, but the hypotheses we reject will always get less of an airing than the ones we embrace – no investor has time to read weekly 50-page deliberations. Why Now? The canonical BCA question – So What? – is meant to keep researchers focused on the market relevance of their inquiries. But we have long advocated for a second question – Why Now? – to keep our focus on timeliness. Spotting imbalances, which can take a maddeningly long time to reverse, isn’t enough to earn alpha. To translate macro analysis into promising investment ideas, an investor also needs to identify potential catalysts that might unwind the imbalance. Bull markets become exhausted once so much capital is invested in them that there is no one left to keep buying, just as bear markets end when the urgency to sell dissipates. Sentiment can offer clues into remaining buying or selling power, and the day before the Grantham piece appeared, an experienced financial advisor with a stellar portfolio management record emailed that, “This is one of the few times in my career where I feel like the market is simple and the consensus is right. It almost always feels like there is something obviously bad on the horizon but this market feels like there is really good news on the horizon.” I have known him for over 30 years and can attest to his intelligence, diligence and savvy. His clients are in excellent hands and his constructive take may well be spot on. Indeed, we hope so, since it dovetails with ours, but his assurance gave us pause. For now, it doesn't seem to be universal, as it contrasted starkly with this musing from another trusted confidante (a family office CIO) as 2020 was winding down, “What can be said about work other than make certain we don’t mistake this bull market for brilliance.” Valuation is a notoriously lousy timing indicator and sentiment is a squishy concept that is hard to pin down. Both can remain stretched for a long period of time. An investor shouldn't bet against them unless s/he has a good reason for believing they are on the verge of reversing. Perhaps not having to run on the relative performance hamster wheel like most professional investors gives the family office CIO, who also has a great track record, a little broader perspective, but every investor could use a dose of humility. Skepticism is an essential component of successful investing as well, especially as stocks are making new highs. If you think it’s not windy … Investment Implications We respect Jeremy Grantham’s experience and formidable accomplishments and listen closely to any insights he’s willing to share. We acknowledge that there are many signs of froth across financial markets and that the Kindleberger red line of purchasing assets without regard to their intrinsic merit could be crossed in the not-too-distant future. We echo the sentiment that central bankers are not omnipotent and that easy monetary policy is not a magical elixir. We do, however, assert that the combination of extremely easy monetary policy and a new round of fiscal aid offers equities and spread product a supportive backdrop that should be expected to hold throughout the year provided that markets don’t get over their skis by bidding up asset prices too far. The bottom line is that market vulnerabilities are cropping up but we disagree with the view that they are about to bring an end to risk asset outperform-ance. We remain overweight equities and spread product while keeping an eye out for anything untoward. As we have been saying for several weeks, we are bullish, albeit vigilantly so. One of our roles is to worry for our clients, and we are scanning the horizon for signs of trouble even more thoroughly than normal. Until we see those signs, or until risk asset prices rise so much that they sour their risk-reward prospects, we will stick with our call. On the last point, we are in complete agreement with Grantham: The one reality that you can never change is that a higher-priced asset will produce a lower return than a lower-priced asset. You can’t have your cake and eat it. You can enjoy it now, or you can enjoy it steadily in the distant future, but not both – and the price we pay for having this market go higher and higher is a lower 10-year return from the peak.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1https://www.gmo.com/americas/research-library/waiting-for-the-last-dance/ Accessed January 5, 2021. Grantham is the octogenarian co-founder of Grantham, Mayo and van Otterloo (GMO), a value-oriented asset manager for institutional investors. 2 McDonald, Michael. "Grantham’s Bear Market Call Tests Patience of GMO Fund Investors," Bloomberg, November 24, 2020.