By Team IntuitEcon
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Asset valuations have broadly risen this year to very high levels across a range of assets. High stock prices and record low spreads on corporate bonds suggests investors are more optimistic about the outlook. Economic data has thus far seemed to confirm this outlook, but a broad range of risks remain. One is broad asset price valuations generally which we detail. However without a real catalyst to send widespread fear we expect these known risks to deliver only short term volatility as they arise. In other words, we believe losses from these risks will be short lived and are thus not changing our thesis. All we did this week to the portfolio was add to Stride ($LRN) after it dropped 12% on no material news.
Macro Risks to the Outlook
Stocks were generally flat the past week despite the VIX rising from under 16 to a close of 19 today. Treasury yield on the 10 year fell from 1.46% on July 1st to 1.29%. The inverse relation between Treasury yields and the Vix suggests a bit of flight to quality more akin to the typical relationships observed in recent decades than early in 2021 when inflation and rising rates drove the risk narrative.
There are always risks to the outlook. One includes concerns that the strength of the reopening is dependent on fiscal support … some of which is likely to be relaxed in coming months such as state level unemployment benefits. There also remains a great deal of uncertainty regarding changes in behavior. Vehicle sales slowed to an annualized selling pace of 15.4 million from 19 million in April. The impact of the pandemic on mobility behavior is a more challenging trend to assess. Economic data during the reopening has been very volatile and it will likely continue in the coming months or years before the implications of these behaviors materialize into clear economic trends.
Another is asset valuations generally. FSOC’s Annual Report for 2020 published in December 2020 included a statement regarding risky asset valuations that’s worth considering …”Elevated valuations in U.S. equities and corporate bonds make these markets vulnerable to a major repricing of risk, increasing volatility, and weakening balance sheets of financial and nonfinancial businesses.” Since this publication stock prices have risen by another 12.5% to 37.96 today as measured by the Robert Shiller Cyclically Adjusted Price to Earnings (CAPE) ratio.
Treasury bond yields have risen in 2021 but remain near century lows. US corporate bond spreads above these treasury yields fell from 1.07 to a new all time low of 88 bps as measured by the BofA US Corporate Index. We show the past two decades below but you can click on the chart and get any range you like. Corporate spreads are a valuable indicator of broader risk sentiment.
Evaluating systemic risks is already challenging given the complex nature of economic and financial systems. As a potential cause, asset valuations add to this complexity. Risk managers have fundamental tools for assessing valuations, but some appear to be more reliable than others. For example, price-to-rent was one of the metrics where the Housing Bubble was readily visible.
Price-to-rent ratios have accelerated since FSOC’s report also, but credit quality (another fundamental tool) as proxied by FICO scores has not been a contributor (Chart). Credit assets generally have more reliable fundamental metrics to gauge price stemming from the “Five Cs” such as capacity, collateral, credit, character, and conditions. These are easier to measure and assess relative to history. No getting around the fact that poor credit history and bad collateral leads to higher probability of default and lower recoveries.
Equity is naturally more complex because unlike the binary outcome for credit assets (default or non-default) there are really no theoretical bounds besides zero. Within equity there is further disparity between more bond-like stocks with consistent dividends and growth oriented tech companies that have increased in proportion to the overall market since the Financial Crisis. Cryptoassets go even beyond disruptive technologies like gene editing that have yet to generate revenue, but are at least theoretically valued based on present value of future expected cash flows.
Many books have been written on the topic of asset valuation … so covering the full spectrum of considerations is not possible here. The point is that many viewed assets as being a systemic risk before the New Year. Prices have continued to rise across nearly every asset class. While we can’t measure with accurate the magnitude of the systemic risk asset valuations pose...we can say with certainty that the risk is larger than December 2020.
So what to do?
There are several reasons why we are not particularly concerned about the consistent rise in asset prices. The first is that we predicted that we expected it. Our main thesis is the #2ndTechBubble and that will likely coincide with a broader increase in asset prices generally. In our writing on this Bubble we argue that you need a different framework for evaluating when to start getting more cautious. We've written about this a lot already on our blog, but suffice to say that we are not anywhere close to a point of euphoria in the assets we hold.
Another reason we are not worried is that benchmark rates were falling this week with the rise in VIX. That was not expected, but is a welcomed change. The biggest risk we articulated heading into this year was the rise in rates caused by fear of inflation. During the first half of the year you saw a reversal of this relationships as rising rates drove the risk narrative. So far it seems Cathie Wood hit the nail on the head with her call two months back on commodity prices being a bit overbought on account of double and triple ordering.
So in conclusion...we are not doing anything to our portfolio.
Bernard and Team IntuitEcon