A bull or bear market for 2021?

And the strongest bear argument to support this is valuations. Current market valuations by nearly all yardsticks — including price-to-earnings (cyclically adjusted or otherwise, trailing and forward), priceto-book, EV-to-Ebitda, price-to-sales and Warren Buffett’s favourite measure, market cap-to-GDP — are near or above historical highs (see Table 1).

What’s more, these are valuations prevailing against a backdrop of global economic recession due to the Covid-19 pandemic, geopolitical tensions, a trade war between the world’s two largest economies, Brexit and rising nationalism. A case in point: One of US President Joe Biden’s first executive orders since taking office is “Buy American”.

We have made our position very clear in recent articles. We remain bullish on the global stock market.

It would not be wise to dismiss the bear arguments out of hand. Yet, globally, stock markets continue to head higher, defying all concerns. And the fact is that the market as a whole is rarely wrong. Only a fool would bet continuously against the market. So, what gives? Who is right or can both be right?

Valuations are more nuanced than just headline numbers

First, let us take a closer look at the bear valuation argument. Yes, the Standard & Poor’s 500 index is currently trading at record-high levels and its forward PE of 22.6 times is higher than the average of 18.9 times over the past five years. However, looking at the headline number — in isolation — is, we think, oversimplification. The reality is far more nuanced.

For starters, much of the S&P 500 gains, particularly in the past one year, were, in fact, driven by a handful of mega-cap, mostly tech-related, stocks. This is justifiable, as many of these companies actually benefited from the pandemic environment — and will continue to reap the benefits of behavioural changes as a result of the pandemic. In other words, the outlook for many of these companies has actually strengthened coming out of the crisis.

In Chart 1, we separated the S&P 500 companies into two baskets — the FAANGs plus Microsoft, Mastercard, Visa, Nvidia and Adobe in one (S&P10) and all the rest in another (S&P490) — and tracked their share price performances over the last few years. The divergence is clear to see.

Notably, the S&P10 companies were already far outperforming the index well before Covid-19. In other words, minus these 10 stocks, the broader S&P 500 index would have risen at a much slower pace — to the extent that we may not even be obsessing over the subject of overvaluation, as we are now.

So then, are the S&P10 companies overvalued? Again, we think their longer-term outperformance is justified — and their share price gains are merely a reflection of underlying earnings performance. Benjamin Graham, often credited as the father of value investing, once said: “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

These companies have, undisputedly, delivered multi-year track records of strong and consistent sales and outsized earnings growth — underpinned, in part, by rising gross margins owing to a steep supply curve typical of most tech companies as well as share buybacks given their strong cash-flow generation (see Table 2).

Granted, they are trading at higher-than-market average valuations — and that, to a certain extent, inflated overall valuations for the S&P 500 index given their size. But remember, absolute PE is meaningless — a PE of 9 times does not mean the stock is cheap and neither does a PE of 229 times render a stock expensive. Valuations are measured against prospective earnings growth and cost of capital (based on interest rate plus risk expectations). We prove this mathematically in the accompanying box article. And the S&P10 are, without doubt, high-growth companies. Earnings per share (EPS) growth averaged 41% in the last five years.

So, while these stocks are, collectively, trading at roughly 42 times forward earnings, they are by no means expensive relative to expected future growth. Their average EPS is estimated to expand 29% this year and will remain robust for years to come.

In the short term, more fiscal stimulus money and pent-up demand will spur consumer spending once economic activities normalise over the coming months, through vaccinations for Covid-19. In the longer term, these companies will be among the biggest gainers from the global digital transformation, which has been brought forward by the pandemic.

That said, there are certainly segments of the market and stocks that are fuelled by excessive exuberance. The manic trading in shares for GameStop — a loss-making company with falling sales and a poor outlook — is one prime example. The relentless rally and eye-popping gains for Tesla is, we think, another instance where expectations have run far, far ahead of reality. Incidentally, with a market cap of US$810 billion (S$1.08 trillion) and priced at four-digit PE multiples, Tesla has no doubt also contributed to the inflated valuations of the S&P 500 index (see box article for further discussion on Tesla).

Box Article: Explaining valuations in the context of growth and cost of capital

The value (price) of a company is equal to the sum of its discounted future cash flows. In formula terms, P = Earnings/(r-g) where r is the cost of capital (based on the risk-free rate plus risk premium) and g is the expected growth rate of earnings.

Of course, in discounting the earnings, r and g are the expected growth in earnings and the cost of capital over the future period when these earnings are accrued. That is, it is theoretically not, say, the cost of capital next year alone but the long-term expected cost of capital.

This matrix shows the fair price (PE) of a company, that is, how much one should pay for each dollar of earnings. The multiples change with different expected growth rates and cost of capital — that is why absolute PE multiples are not very useful for making the right investing decisions.

For instance, one should pay 11 times multiple for each dollar of earnings for Company A, whose earnings are growing at 2% and assuming a cost of capital of 11%. At this same discount rate, Company B with a higher growth of 8% would be fairly valued at 33 times earnings while Company C, expected to grow at 10%, should trade at a far higher PE of 100 times. In short, the higher the expected growth of future earnings, the higher the stock’s fair PE valuation, all else being equal.

Any change in the discount rate (cost of capital) will also affect valuations. For example, if the cost of capital falls by 1% to 10% (say, due to a lower interest rate), the fair PE for Company A will rise to 13 times from 11 times while that for Company C will expand by much more, to infinity (in theory) from 100 times. What it means is that if a company can grow its earnings consistently over the longer run, at a clip faster than its cost of capital, the sky is the limit. This explains why we occasionally see very rational investors paying four-digit valuations for a company now — for instance, Tesla. But we also know the law of diminishing returns dictates that there does not exist such an eventuality.

The above partly explains why market valuations have been rising steadily — in lockstep with central banks progressively cutting interest rates. Stock valuations are near the highest in history because interest rates are at record lows! It is not irrational, it is mathematics.

Additionally, in a very low interest rate environment — such as now — high-growth stocks command significantly higher valuations, relative to low-growth stocks. A case in point: At an 11% discount rate, the fair PE for Company C is nine times that of Company A (100/11) but at a higher 12% discount rate, it is only five times (50/10). This explains why growth stocks have been favoured over value stocks and why, as a group, they have outperformed in recent years.

Conversely, when the market expects interest rate hikes, high-growth stocks often suffer much sharper price falls — because the bulk of their earnings is in the future, which will be worth far less today at higher discount rates.

Market is driven by massive liquidity and historic low interest rates

What is driving such exuberance in stocks? It is probably a confluence of factors — and we have discussed many in previous articles — but the best and most valid reason has to be the massive liquidity and historic low interest rates around the world. When money is almost free, the value of assets goes up. It is a theoretical, mathematical, practical, physical and emotional truth.

Chart 2 shows the massive surge in US money supply last year — as the government and central bank responded strongly to the pandemic. Last year, the y-o-y M2 increase was the highest ever in the US Federal Reserve records that go back to 1981. M2 is a broad measure that includes cash, checking deposits, savings deposits and money market securities.

Graham rightly pointedly out that in the long run, the market is a weighing machine — fundamentals matter — but we think he missed out one very important aspect. And that is, in the world of investing, the keyword is “relative”. There is opportunity cost in every decision — each investment must be compared against the expected risk-return proposition for all other asset classes, be it stocks, bonds, gold, bitcoin, property or simply keeping cash in the bank.

Thus, if we may be so bold as to correct his quote, “In the short run, the market is a voting machine but in the long run, it is a relative weighing machine”. Right now, the scales are tipped decidedly in favour of stocks. As we explain in the box article, very low interest rates justify much higher stock valuations.

In short, stocks are pricey — but as long as liquidity remains high and interest rates are low, the rally has legs. Our strategy would be to look for companies with sustainable high growth, since we have decided on an aggressive portfolio. Still, we acknowledge our optimism on the upside from digital transformation globally is significantly higher than the average expectations. For those who are more conservative or risk-averse, it would be wise to be investing into “value” and consider more defensive exposures such as commodities.

The billion-dollar question: Are low rates sustainable?

That brings us to the next billion-dollar question: Are current low rates — and therefore, high stock prices — sustainable? Intuitively, the answer must be “no” — when you are at rock bottom, the only way is up — though real-world events since the global financial crisis would suggest otherwise.

The key driver behind falling interest rates over the last decade has been persistently low price inflation on a global scale — in spite of the huge creation in money supply. In fact, global inflation has been trending broadly lower since the peak at the start of the 1980s (see Chart 3). Why?

It is most likely a confluence of reasons, including demographics — slowing population growth and an ageing population in major developed countries such as Japan and in Europe — the emergence of China as the world’s factory and globalisation as well as continuous technological advancements and the sharing economy driving efficiency and productivity gains.

In fact, the stubborn absence of inflation has seen major central banks pulling out all the stops to fan inflation, straying far from their traditional mandate of maintaining price stability. Indeed, for years, their biggest worry has been a deflationary spiral, like the one that led to Japan’s lost decade and which still plagues its economy.

We foresee inflation ticking higher in the coming months as economies reopen, leading to increased consumer spending from pent-up demand — particularly when measured against very low comparables in 2020. There is a lag of about six weeks in terms of reporting in the US. The nadir of inflation was in May 2020. So we should start seeing a pickup in y-o-y inflation figures in July 2021. Likely, this may cause some market jitters in the short term, leading to a correction around that time.

Even so, we do not expect it to rise too high — after all, people cannot eat double their usual amount or go to a hair salon repeatedly to make up for times they could not during the pandemic. More critically, we do not believe the rising trend will persist beyond 2021. We think inflation will stay lower for longer.

Inflation will stay lower for longer

Demographic headwinds will continue to weigh on inflationary pressures. Even in China, its population is rapidly ageing and growth has slowed, a legacy of its one-child policy. Some reports suggest that based on the current trajectory, the country’s population will peak near the end of this decade and start to decline thereafter, following in the footsteps of Japan and most countries across Europe.

We also expect rapid technological advancements to keep a lid on costs and prices. As we have articulated a fortnight back, the current digital transformation, often characterised as the Fourth Industrial Revolution (4IR), will have a massive impact across almost every business in every industry and every country of the world. Like the First and Second Industrial Revolutions, it will bring about another great leap forward in terms of efficiency and productivity — lowering costs at every level of the value chain and suppressing overall prices, and raising profits for enterprises. This is yet another reason why we believe the market rally has legs — earnings will continue to surprise on the upside.

In fact, the unfolding 4IR is one more reason why simply benchmarking current valuations against historical ranges is misleading, by not factoring in the huge structural changes that are taking place.

In the absence of sustained inflationary expectations, central banks have all the reasons to keep interest rates pegged near zero.

Central banks will keep rates as low as possible for as long as possible

It could be a matter of survival. Almost every government in the world has thrown everything it has, including the proverbial kitchen sink, at the Covid-19 pandemic.

Indeed, we wonder whether governments have overreacted in rushing out all those massive relief packages, including cash handouts to those not in need of them. The size of the response has dwarfed all those in the past, including during the global financial crisis. We will address this issue in a later article. Emotions are currently too raw to have an intelligent debate.

The fact is that they have — and the massive stimulus packages have resulted in a surge in public debt. Globally, debt-to-GDP jumped sharply last year (see Chart 4). And with President Biden and the Democrats controlling Congress (House and Senate), the US will continue with its deficit spending.

Given the mountain of debt, public and private, central banks are inclined to keep interest rates as low as possible for as long as possible. Even a small hike in interest rates will have a huge impact on the burden of debt servicing and the prospect of paying down the principal amounts. And it would leave less and less available to invest in productive capacities. That will, in turn, impair future growth potential. If debt rises faster than nominal GDP, there will be no room to grow out of our current indebtedness. Indeed, the decline in the marginal increase to GDP as public debt rises is an economic reality and a cause for concern. We will address this in a future article when we discuss the limitations of fiscal policies.

As discussed above and in the box article, current stock valuations and the market rally are being driven by lower and lower interest rates (discount rates). It stands to reason that a reversal could trigger the opposite effect — a collapse in financial asset prices that would, in turn, hurt consumer and business confidence. And that is something every central bank wants to avoid.

Indeed, the US Fed has gone to great lengths to assure markets that it is a long, long way off from raising its short-term federal funds rate. In fact, its stated policy is to target an “average” inflation of 2%. Given that inflation has been running below this level through the better part of the last decade and over the last year, this means the Fed will allow inflation to run above 2% for some time — to achieve this average. And if inflation stays lower for longer — like we think it would — it may be a long time before we see any rate hike of significance.

YCC will pressure the greenback and favour EM currencies and assets

However, while the Fed fixes the short-term rates — now pegged near zero — it has far less control over the longer tenures with the current tools in use. A case in point: The yield curve is already steepening to some degree (see Chart 5). The yield on the benchmark 10-year Treasury has bounced off record lows, of 0.52% in August 2020, and is now hovering around 1.2% while that on the 30-year is above the levels this time last year — on the back of the imminent reopening of the economy and in anticipation of more fiscal stimulus. These yields are still very, very low by historical standards, in fact, the lowest in the 60 years prior to 2020.

Still, a short-term uptick in inflation rates in the coming months could conceivably send jitters through the market and fan renewed inflationary expectations — which could send longer-dated yields even higher, prematurely.

Should this happen, we suspect the Fed will initiate yield curve control (YCC) measures. YCC targets shorter-term rates directly by imposing interest rate caps on particular maturities, in this case, likely up to the 10- year Treasury, which is the reference rate for a wide array of credit instruments. A Fed YCC policy would effectively keep shorter-term interest rates low but will result in the yield curve steepening at the longer-dated end. The last time the Fed implemented YCC was in 1942, to keep borrowing costs low as the US incurred massive debt to finance World War II.

The Bank of Japan adopted YCC in 2016, setting a 0% target rate for the 10-year government bonds. More recently, in March 2020, the Reserve Bank of Australia set a 0.25% target on three-year government bonds. Both policies were effective as the market believes in their credibility, to do whatever it takes to achieve the stated objectives. There is a saying on Wall Street: “Don’t fight the Fed”.

Successfully capping yields — even when inflation ticks higher — would surely diminish the attractiveness of US bonds. That would be excellent news for stock markets — remember, it is all about relative returns. And it is likely to cause the greenback to weaken, reinforcing its secular decline, and favour European and emerging market currencies and assets.

A weaker US dollar in the medium term could well be what the economy needs to reduce its trade deficit and will reflect its weaker competitiveness. This will boost materials and commodity prices.

The longer-term problem of keeping interest rates too low is that it will create pockets of asset bubbles, which could be dangerous, and encourages excessive borrowing, risk-taking and lower future returns on investment. Plus, a low interest rate is a form of wealth transfer — the rich get richer (from rising asset prices) while the middle class pay with savings that generate marginal yields or worse, negative real returns. One solution to address this would be for governments to levy some form of wealth tax. We believe this to be inevitable in the future. It is one reason why we should see capital flight to countries with fiscal surpluses.

As analysts and economists, we believe the right remedy is to gradually manage this excess liquidity and debt, returning to a more stable state of productivity and growth, through high-quality investments and job creation. But taking away liquidity and free money is like removing drugs from addicts. The consequences of the “withdrawal effect” may be beyond the abilities of most democratically elected governments.

Of course, we are under no delusion that we could be very wrong. And often, even the best articulated reasoning can be blown apart by a “black swan” event the very next day. That is what makes investing so fluid, so rewarding and so risky. It is why even with the most optimistic of scenarios, one must still take mitigating measures — to balance the risks and reward and be conscious of the level of risks one can afford. You can never be always right.

The Global Portfolio traded 0.3% higher for the two days since our last update on Feb 3. The gains lifted total returns to 57.4% since inception. This portfolio is outperforming the MSCI World Net Return index, which is up 39.4% over the same period.

The top three gainers were Builders FirstSource (+5.5%), The Walt Disney Co (+2.7%) and Bank of America (+2.5%). On the other hand, Qualcomm (-10.1%), Geely Automobile Holdings (-4.6%) and Microsoft (-0.3%) were among last week’s big losers. Last but not least, we would like to wish our Chinese readers surplus and abundance in the Year of the Ox. Gong Xi Fa Cai.

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.