Broker Check

Buying Brings Growth, Inflation Risk

| January 11, 2021

I was going to start this post discussing how not much has happened because of the holiday season and new year. Markets were closed, many people were off work, no new economic or market data were released, and so on.

Then damage and unrest erupted in Washington D.C. and elsewhere. Yet, to paraphrase Vice President Mike Pence, the people’s business was conducted in full.

So far, markets seem to have largely shrugged off the events (likely because the official business was completed). And Cornerstone will too. The will of the people is certified, and we must stay focused on our priorities.

What Propelled the 2020 Rally?

As our clients and readers know, a top priority at Cornerstone is market analysis. So, early in this new year we’d like to look back on the Federal Reserve and its growing influence on equity markets.

We’ve covered the Fed’s support of markets before, and it clearly helped as the S&P 500 finished at an all-time high of 3,756 in 2020. Last week we discussed how the market is very much counting on forward-looking earnings-per-share (EPS) estimates. But if you look at the S&P 500 chart over the past six months, you'd almost think there was no recent recession, and the pandemic was merely a Hollywood film.

The current EPS estimate of $139.22 for the S&P 500 is 21.6 percent below the estimate of $177.60 at the start of 2020. Yet somehow the index gained 16.3 percent, even though earnings collapsed. Granted, earnings could be up by more than 20 percent in 2021, so the market is expecting some normalization.

But as we look back to 2020, what was really driving this rally?

We believe the most important factor was at the Fed’s balance sheet rose by $3 trillion in 2020. That much money can buy a lot of assets, and the Fed didn't hesitate in doing so.

The Fed buying corporate bonds, Treasuries, and mortgages compressed credit spreads. Those collapsing credit spreads told pension funds and other institutional investors they needed to buy riskier assets to obtain returns, including high yield bonds and stocks. The Fed’s actions also gave institutional investors more dollars to spend on risk assets.

When the Fed is buying $120 billion worth of bonds every month, that means institutional investor accounts at the New York Fed or BlackRock have been credited, and those funds need to be deployed somewhere. Portions of the money may end up in the stock market because pension funds must make calculations of what percentage of stocks they’ll hold.

When looking back on markets in 2020, it’s pretty clear that one of the biggest driving factors of the rally was the Fed. If its balance sheet did not rise by $3 trillion, we highly doubt the S&P 500 would have ended at all-time highs. It probably would have finished about 1,000 points less.

The Years Ahead

We expect 2021 to have strong growth. There is support in place for markets and the economy. Similarly, given the results of the presidential election and Georgia Senate runoffs, we can probably expect an increase in stimulus spending. That should help keep positive momentum and drive recovery on an even greater scale.

However, the forward-looking concern we have is in 2022. That is when we would expect some inflation as the economy normalizes.

The reason we don't see this inflation risk in 2021 in the traditional consumer price inflation is because there's an output gap. In other words, there is slack in the economy caused by the pandemic. Until this gap closes, inflation will be hard to come by, which is why we don’t see it happening this year.

But inflation could occur in 2022 as more people who lost jobs because of COVID-19 get back to work and stimulus payments increase. As such, investors need to be aware that an evolving landscape could further change in different ways as soon as next year.   We will be carefully monitoring this risk going forward.

Big Money Index Update

Our trusty BMI has been overbought for about 5 weeks now which is in line with the 30-year average.  The Big Money Index is now leveling off as the chart below shows.

We believe the BMI has peaked which we previously forecast.  It appears the actual peak reading was 91.9% on December 18th.  This flattening indicates that we have reached a frothy orbital velocity and any meaningful pullback in the BMI would be an indication for the cyclical market pullback/reset that we have been expecting.  But remember, the BMI can stay overbought for extended periods of time as it did in 2020. 

We religiously follow the data though and when the BMI begins to trend downward the market tends to follow.  Don’t become overly worried though as this does not mean that we are bearish on stocks medium or in the long term.  We see this upcoming pullback as a natural market correction.

Securities sold through CoreCap Investments, LLC.  Advisory services offered by CoreCap Advisors, LLC. Cornerstone Financial Services, CoreCap Investments, and CoreCap Advisors are separate and unaf´Čüliated entities.