Executive Summary

• Concerns of asset bubbles have garnered a lot of headlines recently, overshadowing the broader economic fundamentals. However, elevated market valuations suggest caution is warranted.
• U.S. and Developed Large Cap stocks stalled in January, while Small Caps and Emerging Markets continued their strong run that began last year.
• Longer-term interest rates edged higher, causing the curve to further steepen, while credit spreads have narrowed to historically tight levels.
• Another round of stimulus will likely come soon, and along with a supportive Fed, this could support higher growth. But the market can be unpredictable in the short run, so investors need to stay disciplined and avoid speculative bets in this highly uncertain environment.

What Piqued Our Interest

Where to begin? Bitcoin, along with other cryptocurrencies, has increased more than 300% over the past 12 months. Tesla trades at a P/E ratio over 1600 and is worth more than the rest of the auto industry combined. Through January 22, 82 IPOs were launched–the most in January in two decades, according to Dealogic. Of those 82 IPOs, 67 were issuances of SPACs (aka “blank check companies”) which continue to flood the market following a red-hot 2020. In January alone, SPACs raised $25 billion, making up almost a third of the $80 billion raised last year. And last month, an army of social media-driven retail investors collectively bid up heavily shorted stocks, causing a short squeeze against hedge funds and triple digit returns in several heavily beaten down names (which subsequently collapsed!). This all begs the question: Could we be in the midst of an epic market bubble?

Judging by the lofty valuations of certain stocks and asset classes, it certainly feels that way. The S&;P 500 traded at roughly 21.5 times forward earnings at the end of January–down from almost 24 in early September, but still at its highest level since 2000—2001. In comparison, the forward P/E ratio has averaged 17.6 over the past five years, and just 15.8 over the past 10 years, according to FactSet. The Nasdaq Composite, which carries significantly more technology exposure, is notably richer, as it trades around 32.6 times earnings. Of course, markets can trade at elevated valuations for extended periods of time, but we are observing more and more reminiscences of the late-90s dot-com era than ever before.

The big question is whether these speculative fads could be enough to derail the broader bull market in equities that began at the pit of this recession almost one year ago. From a macro perspective, the economic backdrop continues to be supportive, as vaccine distribution is accelerating and COVID-19 cases are starting to taper off after the post-holiday spike. In its most recent World Economic Outlook, the IMF raised its global growth forecast for 2021 by 0.3 percentage points to 5.5%, citing expectations of a strengthening economy later in the year, along with additional support from a few large economies–most notably the U.S. and Japan. Manufacturing in the U.S. continues to improve, with the ISM Manufacturing Index reading of 58.7 suggesting notable expansion in the sector. Corporate earnings in the fourth quarter are still being released, but through January 29, 37% of companies had reported, with 82% of those beating expectations–the second highest beat rate since 2008, according to FactSet Earnings Insight.

As the U.S. stock market has risen by approximately 70% since its trough last March, it appears to have priced in that the worst of this pandemic-driven recession is behind us, even as the U.K., South Africa, and Brazil COVID-19 variants pose a very serious threat in the near term. This causes us to wonder: As both equities and fixed income look expensive on a historical basis, where do we go from here? One useful insight is to follow the flows into and out of open-end mutual funds, ETFs, and money market funds. Using data compiled by Morningstar, we observe that combined U.S. equity funds saw $185 billion in outflows in 2020, even as the market ended the year roughly 20% higher. International funds also declined by $64 billion, while multi-asset allocation funds saw outflows of almost $82 billion. On the flip side, money market funds increased by roughly $700 billion last year, experiencing over $1.1 trillion of inflows from February to May, and then gradually declining $400 billion from June through December. In total, there is roughly $4.3 trillion sitting in U.S. money market funds earning next-to-nothing. If reallocated, it could provide yet another tailwind for risky assets.

Perhaps even more notable, the dual construct of an accommodative central bank, along with additional round(s) of stimulus, could be enough to support asset prices even higher than they are today. At the January FOMC meeting, the Fed held rates near zero as expected, but it also provided several dovish takeaways. For one, Jerome Powell, chair of the Federal Reserve, said it is just too early to be talking about dates on tapering, adding that the whole focus on a Fed exit is premature. He also reiterated that disinflation is a bigger problem than dealing with inflation pressures–all of which suggests the Fed will remain accommodative for the foreseeable future. On the fiscal side, President Biden and the Democrats are pushing forward with another stimulus package that could be in the $1.9 trillion range, and they appear willing to achieve this through the budget reconciliation process with a simple majority vote. Even if the final package is less than the current proposal, the combined impact of direct payments, unemployment assistance, tax credits, aid for small businesses, and more should all have a material impact on the economy. The long-term ramifications of higher debt and potential inflation are very real threats, but these are concerns for another day.

Market Recap

The S&P 500 ended January with its worst week since October, shedding more than 3% to end the month down (-1.01%). Considering how red-hot the index was last year, particularly in the fourth quarter, it’s not surprising that blue-chip stocks took a breather to start off the new year. On the other hand, Small Caps have continued to push forward into 2021, as the Russell 2000 index gained another 5.03% after climbing 31.37% last quarter. As we discussed in a recent commentary, Small Cap stocks have significantly outperformed Large Caps since the market bottomed, and the pace of outperformance has only increased in recent months, as expectations of a broader economic recovery have improved. Across the style front, both Growth and Value had moments of strength and weakness and finished the month roughly even for Large Cap stocks. For Small Caps, Growth gained 5.7% in January, compared to 4.03% for Value. Small Cap Growth stocks are now trading at a forward P/E ratio of 82.3, which is more than double its 20-year average of 35.3. Small Cap Value stocks, on the other hand, are trading at 17.6 times forward earnings, which is slightly above its 20-year average of 16.8. Turning towards individual sectors in January, Energy led the way for a change (+3.79%), followed by Health Care (+1.42%), while the laggards were Consumer Staples (-5.17%) and Industrials (-4.3%).

International stocks were mixed, as Developed Markets traded in-line with the U.S., while Emerging Markets continued to flourish. The MSCI EAFE index declined by 1.07%, with developed Asia slightly besting Europe, the U.K. and Canada. The MSCI Emerging Market index climbed 3.07% higher in January and is now up 27.9% over the past 12 months–significantly higher than the rest of the developed world. As usual, most of this was due to China, which makes up 39% of the index, as the MSCI China index gained 7.36% and is up 41.67% over the past year. Despite how strong performance has been for Emerging Markets, the MSCI EM index still trades at just 15.36 times forward earnings, which is obviously way below the U.S., as well as the MSCI All Country World Index at 20.0.

Returns on fixed income securities were negative overall, but there were several notable pockets of improvement. The Bloomberg/Barclays U.S. Aggregate Bond Index fell by 0.72%, primarily driven by a selloff in Treasuries and higher long-term rates. The yield on the 10-year Treasury continued to edge higher, starting the year at 0.93%, reaching as high as 1.14%, and ending the month at 1.09%. As this occurred, the 10-year/3-month spread has surpassed 1% and appears on track to continue to widen. In this scenario, government securities, particularly in the intermediate and longer time horizon, could see further weakness. On the contrary, credit sectors saw some improvement on the back of tighter spreads, which are now looking historically slim. The option-adjusted spread (OAS) of the ICE/BofA High Yield Constrained Index is now just 3.77%–near its 10-year low of 3.16%. The same spread for the Investment Grade Corporate Index is just 1.01%–compared to its 10-year low of 0.90%. While spreads can continue to tighten on the heels of improving economic activity, it’s sensible to question by how much more.

It’s been a wild start to 2021, as we are witnessing conventional wisdom being challenged around every turn. We will likely hear more and more about the SPAC boom, short squeezes, and obscure stocks realizing double- or triple-digit moves in both directions on a daily basis. Our simple advice is to not let the headlines sway you from your long-term investment plan. The market is being supported by unprecedented levels of both monetary and fiscal accommodation, which conceptually should support future economic growth.

However, the market can be unpredictable, and it’s reasonable to expect sudden bouts of volatility after the run we’ve had, as well as increasing pressure on rates as inflation expectations tick higher. Higher tax rates on some individuals and corporations seems likely under the current administration, and there’s always the potential for a geopolitical action or black swan event to cause more uncertainty. Most importantly, the COVID-19 pandemic is still ongoing, and until we move past it, there is still considerable downside risk.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The economic forecasts set forth in this material may not develop as predicted.