Market Update January 2021 – Stock Market Inflation? 


Moving on to 2021: are there new questions? Or more of the same?  Can equity markets continue the trend?  Will interest rates remain historically low?  Could gold share its safe-haven status with Bitcoin? (Never thought I would write that sentence!)  

While it may have been difficult to be optimistic at the depth of the stock market’s decline in early 2020, the market turned and began its rebound, with the S&P 500 Index closing 2020 with a total return of more than 18%.  In late-March, some had believed prices had declined too far, and those with a “trading” mindset started to come back into the market.  But the case for an “investor” to put capital at risk was anything but clear, requiring a focus on “how” to think about markets before deciding “what” to think of them.  And looking back at 2020 provides perspective for how we should think about the prospects for 2021.  

To “invest” is to put capital at risk, believing without certainty that the asset will reward the investor with greater value.  But as the pandemic interrupted global economic activity, many businesses were adversely impacted, current valuations became suspect and future values looked less certain.  Not a dynamic for a rising market.  Yet markets generally moved higher through year-end?

During the depths of the decline, global financial authorities had taken unprecedented steps to increase the availability of capital, often referred to as “liquidity”.  By improving liquidity through steps such as increasing availability and decreasing costs (lower interest rates), markets were able to continue to find buyers, despite the significant economic uncertainty.  

But how can maintaining access to capital cause asset prices to rise? A simple example of one way improved liquidity can support asset prices despite stagnant or falling corporate earnings and valuations is as follows. Let’s say there is one share of stock and two investors, each with one dollar and Investor A buys the stock for one dollar.  Now, if the Federal Reserve provides a program that allows Investor B to access one more dollar at very low (or no) cost, now having two dollars they may choose to buy the stock from Investor A for two dollars. So, the price moved higher because of the additional funds available rather than an increase in the asset’s fundamental value.  In 2020, it was very possible that the company’s value had not increased during this time, yet the price for its stock would have doubled from $1 to $2!  This dynamic certainly impacted market levels in 2020.

In all conditions, appropriate liquidity is required for the proper functioning of the capital markets.  And this example highlights how liquidity goes a long way towards explaining the market’s gains in 2020 despite the pandemic and political disruptions.  To some degree, we may have pulled forward returns that would have occurred in the coming years.  But the combination of continued support from the fiscal and monetary authorities will be remembered as a significant step towards preventing a much more dire economic condition in 2020.  And watching these factors in conjunction with the continuing global recovery will be significant for managing 2021.

CHART OF INTEREST – Stock Market Inflation? 

2020’s market gains occurred against a backdrop of mixed results for corporate America.  Yet, despite a weak economy, broad market measures such as the S&P 500 Index reached new highs.  This has left some concerned that the market is “expensive” or “has gotten ahead of itself”. 

Looking at chart below, the top panel of the S&P 500 Index does reflect new highs made in a tough year.   But stocks are not only impacted by the perceived future value of the underlying business.  Equally important is the capital available for investment.  If investors have cost-effective access to additional capital, it stands to reason that they will be willing to pay a higher price for a given asset without necessarily requiring an improving outlook for the company’s prospects.  

Now here is where this applies in today’s market.  The chart below shows the S&P 500 Index from 1982 through 2020.  The second panel is the M1 money supply (or “Money Stock”), which is the Federal Reserve’s measure of the most liquid portions of money supply, readily accessible for spending. (We use it here to simplify the concept, although other measures of liquidity provide more specific information for this concept.)  

The third panel represents the S&P 500 Index adjusted for growth in the money supply (i.e., increasing liquidity), representing the market’s performance without the impact of the growth of M1.  Taking this into account reveals an interesting observation, as the S&P 500 Index’s 2020 performance looks much more modest, having been driven by rapidly increasing capital in the financial system as opposed to heightened speculative periods such as the late ‘90s.  It also suggests that market gains due to economic recovery since the Great Financial Crisis of 2007-2009 have been modest when discounting the absorption of added liquidity.  And some might say that the 2020 rebound looks more like inflation in the market as the spike in M1 growth correlates with nearly all the gains. 

2020’s M1-adjusted S&P 500 Index results suggest that the central bank’s unprecedented stimulus programs have been an important stabilizer for markets during the pandemic.  Looking forward to 2021, this relationship will be helpful to see if (1) markets can continue their advance with a gradual “handoff” from policy support to economic growth, or (2) will markets continue to need this support (further liquidity injections) to further the advance, or (3) will markets lose momentum without the assistance of monetary stimulus.  How this plays out will provide a great deal of insight into the quality of the global economic recovery.

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