February 19, 2022
Investors have become so conditioned to prices rising, that it is a wonder that markets are continuing to fall. Unfortunately markets are dealing with a risk which it can’t effectively measure with the tensions over Ukraine and the Russian threat to the country. So prices are moving down. Perhaps these are more buying opportunities, but the intraday reversals are less pronounced than they were two weeks ago.
There is little chance that bulls will find cheer in this section of the interweb. Markets remain way (way) too high based on fundamentals, but that condition may persist for a very long time of course. One of my favorite charts is the one showing the level of the S&P 500 vs. interest rates, in this case, the 10 year treasury (see chart below). The last time I took a long look at this the 10 year treasury was around 1.5% (lower blue line). This week it pushed over 2.0% for a time before backing off slightly as the Ukraine/Russia tensions ramped up (upper blue line).
While it may seem foolish to look at this so simply (because taxation is another major factor), it is still reasonable to suggest that the last time interest rates were this high (in Q3, 2019) they were headed DOWN and the S&P 500 was at 3,500. That is about 20% below its current value. The last time interest rates were at this level and interest rates were headed UP (in Q3, 2017), the S&P 500 was at 2,700. That is about 38% below where it is now.
There is a wide variety of things to be optimistic about in the world. The Olympics are on and great feats are being accomplished. There is innovation in the world and some of those innovations may make things more efficient. The restrictions related to the COVID-19 pandemic are coming to an end almost everywhere. These are things to celebrate. It might be worth considering that the current exuberance in markets was a direct result of massive government stimulus and not directly related to some meaningful and positive economic development.
To recall what the pandemic has done to debt levels, simply look at the US Federal Debt since the start of the housing crisis. The debt has gone from about $9 trillion to about $29 trillion. An increase of $20 trillion. With that money contemplate what has become better in the United States of America. None of the significant social problems were resolved. Few, but not most of the major infrastructure problems have been resolved. The country is more divided and the list goes on.
It may be helpful to put some numbers on this. In 2019, before the pandemic, the US paid $574.6 billion in interest. On $23 trillion in debt that works out to about 2.4%. If the interest rates went back to that level (they have) the payments on $29 trillion will be about $723 billion, an increase of $149 billion or about $400 per person. There is every indication that interest rates need to go even higher, but it may be too early to get too negative.
The battle for the hearts and minds of investors is getting really interesting. During 2021, the market saw massive dislocations with meme stocks like AMC and GameStop rocketing higher on almost no news. While companies linked to the ‘shut-down’ economy and electric vehicles soared as well.
These themes are starting to unwind. Collapse would be too strong a word, but the poster child for the unwind is currently Cathie Wood of ARK Innovation ETF. Her flagship fund is down about 59% from its highs in early 2021, and while the media is highlighting the downturn, it is better to focus on the market mechanics that allowed the run up rather than the manager who is just doing a great job marketing the strategy.
In essence there is a common misconception that all of these really interesting little companies will be successful long term, that they will create long term value, that they will be acquired for ridiculously high prices and that the world will be able to absorb their products and turn them into mass market darlings.
Of course this isn’t true. The funds biggest win is Tesla which is now a profitable company making electric vehicles. The problem is that when Tesla was fighting for survival (just 4 years ago), they were the beneficiary of massive government stimulus, government incentives, being (almost) the only player in a niche but really interesting market, and they got lucky. Tesla now has a valuation that is higher than ALL of the car manufacturers combined, yet makes less than 1 million cars per year. The sales of those cars is still significantly dependent on rich people and government incentives.
It is too early to say that these excesses will unravel back to some sort of normal like we experienced in 2019, but the trajectory will have to, if it hasn’t already, turn down. Perhaps it will simply stall until humanity has time to absorb upheaval from the last two years (or 14 years depending on how you count).