Stock Prices Are Dropping Fast — What Happened?
(Not intended to be investment advice)
What a week. The ebullient markets of just a week or two ago now seem like a distant memory. The stock market is volatile and scary again and everything seems to be going down.
But it’s also important to keep things in perspective — despite all the turbulence, markets are just a bit off their all-time highs.
Why Is This Happening?
The technical answer is that interest rates on longer duration Treasury bonds are rising. This increases the expected return of bonds and makes them more attractive relative to stocks. It also increases the rate with which we discount the future cashflows of the companies underlying those stocks — significantly decreasing the present value of cash flows that occur far in the future.
Many of the frothiest growth stocks of the past few months relied heavily on this favorable discounting (zero rates) and general suspension of disbelief to support their sky high valuations. Now that rising inflation (red line below) and growth expectations are pushing rates up (blue line below), the math no longer works.
It’s odd that a relatively small rate rise can kick off this much volatility. It’s also odd that markets are selling off at a time when COVID finally seems to be headed towards a reasonable resolution and the economy seems to be normalizing. Then again, as we’ve been reminded so many times over the past few months — the stock market is not the economy. Stocks surged in 2020 despite a terrible economy and a raging pandemic.
This brings us to the real answer for why stock prices are plummeting lately — because they’re so damn expensive. All the zero rates, QE, and fiscal stimulus pushed stock market valuations up an incredible amount. Not a lot has to go wrong for a fragile house of cards to fall, and I suspect the house of cards is finally starting to quiver a little bit.
Whether this quiver turns into a crash depends on what the Fed does next. If they commit yet again to QE and buying bonds, they could calm markets down. But will they and should they? Inflation expectations are already rising fast thanks to the ongoing economic recovery. Firing the QE cannons would only make them rise even faster, putting even more pressure on long duration bond yields.
It might turn into an ugly feedback loop where the more money the Fed spends buying up bonds (which keeps yields low), the higher inflation expectations go, which puts pressure on bond yields again, forcing the Fed to buy even more bonds, and around and around we go.
To make inflation-related matters worse, there’s also another round of stimulus incoming.
Has The Bond Bull Market Finally Ended?
Back in December of 2020, I wrote the following about Treasury bonds:
The bull case for many risky assets (such as stocks) seems to be low or negative rates forever. The bull case for crypto and precious metals is high inflation, dollar debasement, and persistently low or negative cash yields. Both groups of assets are soaring. Yet if inflation starts spiraling out of control, interest rates will likely rise, especially on the long end of the yield curve where the Fed exhibits less control. Higher interest rates would crush risky asset prices and bring down inflation. In an ironic twist, shorting Treasury bonds (rather than owning them) might be the best hedge for the risky assets in your portfolio going forward.
Personally, I head into 2021 with a portfolio that balances aggression (tech stocks and stocks poised to do well if the vaccine is a success) and caution (covered calls, index shorts, and put options on Treasury bonds). If markets keep surging, I’m prepared to underperform because of my various hedges. If things take a turn for the worse, the preparation I did in advance will allow me to sleep well at night. Good luck and happy new year!
The Paradox Of Investment Bubbles
Not intended to be investment advice. Opinions are my own.
I still think that shorting bonds (full disclosure: I own put options on TLT) is the way to go. In a normal economy, a Treasury bond should pay a rate that’s higher than expected inflation. We’re a far cry from that right now (see earlier chart on inflation expectations and Treasury yields).
And yes I know we’re not in a normal economy right now, rather we’re in a Fed-distorted one. But even so, short-term rates are already at zero so the Fed’s only avenue to lower yields is more QE. And as we observed earlier, more QE coupled with economic recovery and fiscal stimulus would significantly increase inflation expectations. It’s one thing to print money during an economic lockdown when there is a huge demand hole to fill, it’s another thing entirely to print money when economic growth is already picking up.
Thus, it’s a bit of damned if they do damned if they don’t.
What About Equities?
I honestly have no idea what happens next. Nobody does. Rising yields and high valuations are generally a bad combination for stocks, but the market has prospered through worse.
I’ve written significant amounts of calls against my shares over the past few months, so I will look to buy some of them back at advantageous prices if this decline persists. My largest holdings are in stocks of companies with substantial profits and continued growth opportunities. So even in the event of a market crash, there’s a floor valuation created by these companies’ profits, assets, brands, and economic moats.
On a related note, the shares of mega-cap tech companies like Google, Amazon, Microsoft, and Facebook (full disclosure: I own them all) are looking relatively cheap these days in comparison with the rest of the market, and especially smaller tech companies. They are all highly profitable, own tons of cash, and growing at double digit rates despite their size.
Great bubbles take months if not years to fully deflate with multiple mini rallies and crashes in between the peak and the ultimate trough. But they also create massive buying opportunities in risky assets. Whether this bubble has really burst will only be obvious in retrospect — but do keep your eyes peeled for attractive opportunities. Just as it’s best to take some profits on the way up, it’s also advisable to get greedy on the way down.