We face peak market uncertainty in 2022 as rate hikes give way to 2021’s easy liquidy. The Fed will stop expanding the balance sheet by March 2022 and it plans three rate hikes next year. This assumes core inflation falling sharply, whereas we see core inflation staying high even as headline inflation eases next year. The Fed’s belated focus on inflation, just as prices became Washington’s top issue, raises risks they overtighten to control inflation. This is the higher probability outcome even though a flatter bond yield curve points to growth worries. We suspect central bank liquidity has attenuated the pricing signal historically provided by the bond market. With the outlook murky, we remain flexible to changing views if data evolves.
US Equity valuations remain elevated in both absolute and interest rate-adjusted terms. Inflows into equity funds surged in 2021, matching those of the past two decades combined! Surging meme stocks prices and rising options activity illustrate the exuberance. A good portion of the price gains have come from rising valuation vs. higher profits. Corporate stock buybacks offer a countervailing positive trend that is likely to persist.
Liquidity has also poured into digital assets and impacted the riskiest part of the crypto universe. Digital assets are likely to correlate to risk asset moves in the short-term. The Dispatch is debating two core views for crypto for 2022 and beyond: 1) Will institutionalizing protocols like Bitcoin, with high futures volume, break the past boom-bust price cycles and actually provide upside? 2) Will newer, faster, cheaper utility protocols continue exponential adoption growth in a downturn, driving gains vs. BTC/ETH? A downturn will allow us to see how much of this exponential adoption is real vs. speculative activity attracted to high prices.
Dispatch #40 is the final 2021 publication. We are grateful for our readers and appreciate the feedback that was offered. As a vintage 2021 start-up, it’s good to hear that our thoughts connect! The full discussion line up of The Dispatch follows:
- State of the equity market as we end a boom year
- Liquidity has numbed the bond market signal
- Crypto asset: does the cycle evolve in 2022 beyond boom & bust?
- China is easing as expected
Peak Market Uncertainty in 2022, after a strong 2021 run
Extended Equity Valuations and worrying deterioration in breadth
This meme sums up the price action in 2021. We had crazy price moves through the middle of the year, but many of the excessively valued stocks have declined lately even though mega caps continue to support the S&P 500 and the NASDAQ.
The S&P 500 index price return is 23% YTD as I type. Underneath the index strength, which is supported by a handful of mega caps, there’s been quite painful share price moves. This metric of the breadth of the NASDAQ is a good indicator of this diverging performance.
While margins and earnings have been strong, valuation re-rating (grey area in the chart) is the largest contributor to returns since Covid. These chart provides a longer-term decomposition of S&P 500 returns, which agains shows that grey color dominating for the last decade or so.
Source: Variant Perception. Note: T12M = trailing 12 months
Long term valuations are approaching 2000 levels
As a result, the cyclically adjusted PE, also known as CAPE ratio, is elevated today. We are approaching the extreme levels observed during the 2000 tech bubble. The CAPE ratio has been a good predictor of long-term returns because it captures the cyclicality of economies, margins and valuations. Yes, there’s structural technology innovation, but that existed in the past with the discovery of crude oil, microprocessor, software, etc. Innovation is not unique to the past five years.
The typical dismissal of the CAPE ratio revolves around the technology innovation and low rates. However, even if you adjust the CAPE ratio of today’s low interest rates, the chart below show that it remains elevated. Historically, CAPE ratio has predicted long-term (10-year) returns accurately, but has a poor record of predicting returns shorter than 5 years.
Actual vs. predicted CAPE ratio based on interest rates
S&P500 CAPE ratio and interest rates by decade
Global Central Bank liquidity is impacting markets
You may be asking, why worry about cyclically adjusted PE when we don’t have cycles anymore!! The last one was in 2008/09, and since then central banks (CBs) liquidity has prevented any economic downturns. As the chart below shows major central bank liquidity is now 29% of world GDP. It was at zero pre-2008, when this money printing experiment started.
Inconveniently for politicians and central bankers, all that liquidity coupled with pandemic disruptions caused inflation to spike. Inflation is now the number one political issue and CBs will need to reduce this liquidity to get inflation under control. The Fed has belatedly pivoted to an inflation focus, and is guiding for three rate hikes in both 2022 and 2023. This rate hike prediction is based on their view of core inflation dropping sharply in 2022. In contrast, we see core inflation staying stubbornly high, even as headline inflation eases next year. If our inflation view is accurate, it may push the Fed to overtighten interest rates and stall the economy.
Stock fund inflows = last two decades combined
With the central bank liquidity put firmly in place, we’ve witnessed historic equity inflows in 2021. (“central bank put” : the view that central banks will print money to support markets at the first sign of market weakness. )
Retail speculation exploded
There is clear evidence of market froth with the rise of unprofitable meme stocks and rising call option activity. The chart below shows how call option activity since Covid has diverged from the long-term trend of relatively balanced call and put option volumes. This WSJ article explains how options activity tied to meme stocks have exploded.
Rising insider selling
Company insiders know the prospects of their companies best. The aggregate dollar value increase is not alarming because of share price rally. There’s a more notable increase in sale of >$200m, which again is no surprise given the outperformance of large caps over small.
Source: WSJ
On the positive front, stock buybacks have reached new highs and could remain at these levels considering cash levels at large corporates.
Are bond markets accurately predicting the future?
The flattening bond yield curve in December has led to pundits claiming that the markets are signalling that rate hikes will cause growth to slow. That is certainly one of the possibilities, but there’s evidence that the Central Bank liquidity has removed the market price signal. In the past the market sniffed out the correct direction of travel ignoring Fed guidance. That relationship could be broken due to the vast central bank liquidity injection.
This week provided evidence of the market following the Fed. Here’s Robin Brooks, Chief Economist of the Institute of International Finance, explaining.
This chart shows how market projections of Fed fund rate has followed the Fed guidance. We’ll take market signals more seriously once the Fed gets out of the markets by ending QE in March. Finally, we would NOT be surprised if the Fed brought forward the taper and ended QE before March.
This intraday chart of the TIPS (Treasury inflation protection securities) shows the volatility as Powell speaks. This is another example of the market is merely reacting to Fed guidance/talk, as this economist notes. Inflation expectations reflected in TIPS rates shouldn’t move to Powell’s words!
The Dispatch is closely watching market signals as the Fed stops QE.
Crypto asset outlook
Crypto markets are ending 2021 even stronger than traditional assets. There’s been a dramatic broadening of the asset class with an explosion of new base layer protocols, new decentralized application and all new categories like blockchain games and NFTs. Bitcoiners’ beloved stock-to-flow model proposed by researcher PlanB is misfiring. The price targets in the model have been missed in the first third of the post halving period. With increasing institutional flows into bitcoin, the known halving event is likely to be priced sooner in the future. Perhaps the boom-bust 4-year halving-led price cycle has ended.
Source: PlanB via Twitter
Capital in this cycle has moved on from bitcoin and gone in the 1000s of new alt tokens. That’s where you turned a $10K investment into millions. This is also far out the risk curve where many of the projects may not survive a cycle, however the cycle looks moving forward.
Where does that leave crypto assets in 2022 and beyond? There’s vastly more capital in the asset class now and this is likely to lead to mini cycles within each sub-sector. Bitcoin remains the pristine asset that is likely to outperform during down markets, but we wonder if outperformance will translate into absolute fiat dollar upside.
How will the future evolve?
This tweet thread by the founder of Multicoin capital on the evolving asset class, resonates some. He is a backer of Solana (SOL), so keep that in mind when you read the positive take on SOL in the full thread.
Our key misgiving is that just as SOL is gaining on ETH, what’s to stop a faster, more efficient Layer 1 blockchain from taking share from SOL over the next ten years. This could well be a speed race as human ingenuity continues to develop better protocols for decentralized services. Our bias is also to suggest that macro plays a much larger role in the short term, than these tweets acknowledge. The world has seen an unprecedented liquidity flood and that liquidity has greater impact on smaller assets like crypto.
Are the network effects as large as they appear?
Finally, in the current froth, what appears to be exponential network effects may prove to be just a small number of people trading among themselves. We’ll only know when the tide goes out or with passage of time. The NFT boom is a clear case of single individuals trading with multiple wallets. Each wallet is considered a new user, which then gets you to exponential adoption, a term that The Dispatch has often used to explain digital asset growth. Without direct cashflows, digital asset values rely heavily on user growth and network effects. Given the pseudonymous nature of decentralized blockchains, it’s not straight forward to figure out user adoption.
Price return of select digital assets and the S&P 500 over the last 6 months
Source: TradingView
We remain constructive long term, but the rising macro risks will be a headwind for crypto assets too. It doesn’t take too much intelligence to suggest that a global risk-off event, that takes correlation to one, could eviscerate crypto. However, crypto should be fine in a year-2000 like selloff, where capital rotates from high growth to value sectors. This is the most likely path, and The Dispatch aims to use our macro-overlay while we seeks out the latest innovations. What are the previously unimagined evolutions in 2022, just as we saw blockchain games (Axie Infinity), NFTs and DAOs hit the crypto mainstream in 2021.
China evolving as planned
China finally started to ease interest rate policy as economic activity slowed, led by the property sector. In early December, policy makers used their preferred easing tool by cutting required reserves of banks by 50bp, releasing Rmb1.2tn of liquidity. As with most policy measures, the impact will take time. In November, economic activity was sluggish, which means more policy easing is likely. See Dispatch #37 and Dispatch #33 for our ongoing thought on China macro.
Evergrande default is playing out with no market turmoil
The Evergrande saga is playing out as anticipated here. Chinese equity and debt markets have remained calm despite official default status. In fact, Chinese high-yield bond spreads have improved into the official default announcement. This is a good example of markets correctly sniffing out and pricing default risk.
This WSJ article lays out the playbook of keeping property buyers and onshore retails lenders whole, while offshore lenders are likely to see haircuts. The value of equity is anyone’s guess but don’t be surprised if the government shows up owning a chunk of these defaulting entities.
The Dispatch’s key fear was that President Xi would usher a new era and rapidly deleverage the real estate bubble. The policy easing suggests this low-probability path is not likely. However, Beijing tightening information distribution shows the regime is still concerned about the current environment.
However, as Beijing based Prof. Michael Pettis observes in this tweet, China has large imbalances built up over many decades.
It’s not possible to remove them quickly. We recommend reading the full tweet thread from Prof. Pettis.
China stock valuations have de-rated
Source: UBS
Given the changes and lower valuation, The Dispatch is finally warming to China and emerging markets exposure after many years. Furthermore, many EM economies, unlike China, have already raised rates aggressively, tightening financial conditions. These markets will need a weaker US$ to convincingly outperform. That’s unlikely in 2022 as real US$ rates become less negative with Fed tightening, but valuations are attractive from a long-term perspective.
Stay safe, have a Merry Christmas and a Happy New Year. Please reach out if you have any questions or comments about the material in this Dispatch.
Asi
Important Disclosures
| This is not an offer or solicitation for the purchase or sale of any security or asset. While the information presented herein is believed to be reliable, no representation or warranty is made concerning its accuracy. The views expressed are those of RockDen Advisors LLC and are subject to change at any time based on market and other conditions. Past performance may not be indicative of future results. |