Be cautious when everyone is bullish

(NYTIMES) – As Covid-19 vaccinations spread, the stock market has been generating fabulous returns. Many of the economic numbers have been nearly as impressive. If you have held on to broadly diversified stock funds over the past year, reading your latest portfolio statement will be a joyful experience.

Savour those exorbitant gains while you can. But when numbers this gaudy appear, it’s worth asking why. And, unfortunately, the most accurate answer is probably the simplest: Things were so terrible a year ago, they had nowhere to go but up.

There have been a few mediocre stretches in the stock market lately. But compared with the early days of the pandemic in the United States, we have entered a period of balm and bliss. The endless tragedies of the past year, followed by a partial, cash-infused recovery, have skewed the numbers enough that any comparisons should be taken with an entire shaker of salt.

But there are harbingers of trouble already: signs of incipient inflation, rising bond yields and occasional tremors in global markets in response to coronavirus flare-ups.

For the most part, though, these portents are being muffled by the profit making.

Recall how bad it was

When people began to sicken and die and the awful toll of the coronavirus began to be understood, the markets and the economy crashed.

Those are not words I’d use casually, but they are appropriate here. In a little over one month, from Feb 19 to March 23 last year, the stock market fell 34 per cent.

As businesses shuttered and workers stayed home, the US’ gross domestic product (GDP), a broad measure of goods and services, plummeted. GDP fell 5 per cent in the first quarter of last year, and more than 31 per cent in the second.

The unemployment rate surged more than 10 percentage points from March to April last year, nearly reaching 15 per cent. That was the highest level and the biggest increase since the Bureau of Labour Statistics began collecting data in January 1948.

The Biden boom

All of this is contributing to what looks like a “Biden boom economy”, as Princeton economist Alan Blinder called it in The Wall Street Journal. Economic growth may exceed 7 per cent for the first quarter this year, and will almost certainly be spectacular for the year as a whole, when compared with last year.

But there’s the rub. These annual economic and financial numbers are comparisons with the depths of the pandemic. The statistics are warped, inevitably, by “base effects”, which is to say, in economic jargon, that the coronavirus-induced recession last year is making many current numbers look unnaturally high.

Inflation

Harvard economist Alberto Cavallo, who has studied inflation deeply, told me that by altering consumption and supply patterns radically, the pandemic has had many subtle effects. Lower-income people, for example, who pay a higher proportion of their income for food, have experienced greater inflation than those for whom food is a relatively minor expense.

On the supply side, he said, a vast array of items became difficult or impossible to find as supply chains were disrupted. Because of concerns about the “fairness” of raising prices during a global disaster, many distributors refrained from doing so. They have started now, he said. And prices have begun to rise on items for which demand is reviving, such as fuel and transportation. As a consequence, inflation is indeed increasing, and worries that it will continue to do so have contributed to rising yields in the bond market.

Both the White House Council of Economic Advisers and the Federal Reserve have taken a rosier view of inflation, saying that although the numbers will probably rise over the next several months, they are likely to abate over time and won’t threaten the economy.

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Risk abounds

The risk is there, even if it’s not widely recognised. You don’t need to be a disciple of the great monetarist Milton Friedman to see it. He once said: “Inflation is always and everywhere a monetary phenomenon.” Well, the Fed has been pumping money into the economy since the start of the pandemic, and the money supply measurement, known as M2, is increasing as rapidly as it ever has in modern times. By the end of this year, it is on track to expand by 40 per cent above its pre-pandemic level.

As Mr Ian Shepherdson, chief economist of Pantheon Macroeconomics, an independent research firm, put it: “Nothing remotely like this has ever happened before, and you don’t have to be a monetarist to regard such a massive monetary expansion as a potential inflation threat.”

There are other threats to the recovery and the bull market, too many to enumerate. The possibility of calamity cannot be ruled out, as economist Robert Shiller observed in a look back at the effervescent 1920s, which ended in the Great Depression. Bonds, which are lagging now, are likely to outperform stocks if the market turns really ugly, which is why I hold some bonds.

If you believe that you are likely to get stronger returns from the stock market over the very long run, as I do, this is a time to prepare for a bumpy road ahead. Hang in there, but don’t be too greedy.

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