Insights

Summary:

• Central bank policies that have increasingly shifted towards keeping equities bid up, have resulted in asset price bubbles across all major asset classes in the US.
  • • • interest rates, that were already low, were driven towards zero bound and were pinned there for an extended period.
      • Fed’s balance sheet, that stayed around 6% of US GDP for nearly 50 years, increased to 36% by July 2021!
• Asset price bubbles across all major asset classes
  • • • S. housing prices, adjusted for inflation, have reached similar extremes as 1910s, 1950s, and 2006s.
      • Bond rates were at -2SD and we’re in the bubble territory as well. Importantly, investors in high yield bonds were willing to accept some of the lowest spread of the past 25 years – this was on top of an excessively low “risk-free” rate. Clearly, risk wasn’t just mispriced – it wasn’t being priced at all.
      • US equities have been priced in the most extreme zone and have been extremely expensive in comparison to the rest of the world.
• As a result, household net worth as a % of US GDP moved into uncharted territory. If this ratio were to just get back to the trend, there will be an immense loss of accumulated “wealth”.
• As inflation picked up and interest rates moved upwards, there was a significant “value” destruction, especially so, in the most speculative segments of the market.
• Constructing sensible portfolios in such an environment requires investors to carefully consider risks and be willing to shun index benchmarks.

N.B.: This note was sent to our investors as part of our 2021 Annual Letter letter which was circulated in January 2022.

“How do we know what we know? How do we know that what we have observed from given objects and events suffices to enable us to figure out their other properties? There are traps built into any kind of knowledge gained from observation.” – Nassim Taleb

“Perhaps, however, it was the epoch that made the man as opposed to the man that made the epoch.” – Bill Gross

As we have highlighted in our previous notes, one of the primary trends of the past four decades has been the declining interest rates globally. Figure 1 and Figure 2 show the trajectory of interest rates in the US, Germany, Switzerland, and Japan. Over the last few decades, starting with Alan Greenspan, the Central Banks have used interest rates as a tool to prop up the economy. However, what began as a way to prop up the economy has increasingly shifted towards ensuring that equity markets are bid up.

Figure 1: US Interest Rates

Figure 2: Interest Rates in Other Developed Markets

As the aftermath of the Global Financial Crisis saw the interest rates staying pinned to the zero-bound, the Fed engaged in alternative monetary policy actions in its commitment to prop up the equity markets. Figure 3 shows the Total Assets on the Fed’s Balance Sheet as a percentage of the US GDP. Having stayed around 6% for nearly fifty years, the ratio had increased to 36% by July 2021.

Figure 3: Fed Total Assets as a % of US GDP

All these actions of the Central Bankers have resulted in a bubble in asset prices. As Grantham highlights[1], we have simultaneous bubbles across all major asset classes for the first time in the US.

Housing price bubble. It is hard to fathom that policy makers have allowed another one to take shape within a decade of the last housing bubble bursting. Figure 4 shows the US House Price Index on an inflation-adjusted basis. As is seen, we are well above the trend.

Figure 4: US House Price Index, Real

Data source: Òscar Jordà, Moritz Schularick, and Alan M. Taylor. 2017. | OECD, Housing prices | S&P/Case-Shiller Home Price Indices and CPI, Fred.

Figure 5 shows the deviation of housing prices from trend levels. As is seen, we are currently above +1.5 sigma level.

Figure 5: US Housing Prices – Deviation From Trend

The bond bubble. As noted in our 2020 Annual letter, “Having trended lower for nearly forty years, rates worldwide have reached close to zero or have turned negative. When interest rates are negative or close to zero, as is the case currently, the very first component of the required return, compensation for inflation itself, is questionable. When accepting such low rates, investors make an implicit assumption that inflation will stay close to zero or negative for extended periods. Of course, the idea of compensation for other components doesn’t even arise unless one is pricing a deep and extended deflation.”

Figure 6 shows the behavior of real interest rates as against the average of the past forty-five years[2]. At two-sigma as of this writing, real interest rates are indeed in the bubble territory.

Figure 6: Fixed Income

As seen in Figure 7, credit spreads further reflect the mispricing of risk in the fixed income asset class. While the “risk-free” real rates themselves are poorly priced, investors in high yield securities are willing to accept some of the lowest credit spreads of the past twenty-five years.

Figure 7: US High Yield Option-Adjusted Credit Spreads

The equity bubble. As highlighted in our earlier notes, the broader US equity markets are priced for poor investment returns. Figure 8 shows the valuations of global equities. As seen, the US equities are much more expensive than the rest of the world.

Figure 8: Global Equity Valuations

Source: Topdown Charts

Figure 9 shows the pricing of the ten largest US stocks. To make a healthy return on such stocks, investors will need to realize very high terminal multiples.

Figure 9: Expensive Largest US Equities

Source: Bloomberg

Asset Price Inflation. All these asset price bubbles have resulted in an unprecedented increase in household networth. Figure 10 shows the US Household Networth to GDP ratio. While this ratio was already in the all-time high territory heading into the Coronavirus crisis, it has gone vertical since.

Figure 10: US Household Networth to GDP

As shown in Figure 3, the Fed’s balance sheet has expanded significantly since then. Figure 11 plots the Fed’s Total Assets and Household Networth, both stated as a percentage of the US GDP, since October 2008. As is seen, the correlation between the two series over this period is a rather meaningful 87%.

Figure 11: Fed’s Balance Sheet and Asset Price Inflation

Consumer Price Inflation. US inflation, which had trouble getting to 2% at the time we wrote our last annual letter, has since risen significantly. The Dec 2021 reading of 7.1% was the highest such reading since 1982. Not surprisingly, markets are reacting by pricing interest rates upwards.

Figure 12: US Inflation – CPI YoY Change

The last few months have seen a significant repricing of risk within the equity markets, with the most speculative stocks registering substantial declines. In contrast, the broader equity markets have held up. As shown in Figure 13, nearly 40% of the Nasdaq stocks were down more than 50% from their respective 52-week highs.

Figure 13: Meltdown in Tech

Source: Sentimentrader via Topdown Charts

Figure 14 shows the performance of a group of more than ninety companies categorized within three baskets. These are stocks included in most high-growth portfolios and have typically been classified as the next-generation disruptors. As Tradingview’s system limited us to forty companies in each basket, we had to create three baskets to include all the companies. Interestingly, while these three baskets are created only based on an alphabetical sort, they have almost identical price action. Each one of these baskets is down about 70% from their highs.

Figure 14: Value Destruction in Speculative Stocks

Source: Tradingview

Constructing Portfolios in Such an Environment

We think the following note from our 2020 Annual Letter applies verbatim to the environment we find ourselves in. “The task of constructing multi-generational portfolios isn’t as straightforward as combining a bunch of assets or relying on the traditional 60:40 portfolios to do the job. Sensible portfolio construction in such an environment requires careful consideration of risks, expected returns and a willingness to shun index benchmarks.”

Appendix

[1] Let the wild rumpus begin, Jeremy Grantham, January 20, 2022

[2] We have calculated the real interest rates as nominal interest rates minus inflation expectations. Inflation expectations have been derived as the average of University of Michigan Inflation Expectations and the 10-year breakeven inflation rate.