Contrarian View

Based on most posts I’m seeing and a poll I recently posted, a lot of people are pretty optimistic about the next year. (Only 8/136 people were very pessimistic.) Here are some risks to watch out for:

1) Healthy economy means healthy stock market, right? Nope. The stock market is a leading indicator meaning it predicts movements in the economy, not the other way around. When COVID hit, the market slumped before layoffs occurred.

People think the stimulus checks will boost the market. If this is because people are buying stocks, it could provide a short lived lift to the market but if I get $1400 and buy 3 shares of Tesla along with everyone else, that does nothing to change the long term trajectory of the company. Tesla doesn’t suddenly become more profitable. If the predicted stock boost comes people will spend the stimulus checks, this is a bit more compelling but brings us to...

2) Inflation - a likely side effect of the stimulus is inflation. Don’t get me wrong, the fed have been trying to induce a little inflation for years. Now congress is helping through stimulus payments. Also on the agenda is raising the minimum wage, green infrastructure, etc. All of which should help working families. But as wages increase, costs to businesses increase, the definition of inflation. If you know a dollar today will be worth 2% less in a year, bond holders will want more interest and interest rates go up. Why is that an issue for stocks?

3) Valuations - any stocks price is a function of discounting future cash flows. As interest rates go up, discount rates go up and the present value of future cash flows goes down. Companies that are promising lots of cash flow years in the future but have little cash flow today get hit the hardest. To be clear, nothing has to change at the companies. They can still be perfectly viable businesses long term. It just means what someone is willing to pay for the promise of future cash flows has changed. This is why the talking heads are talking about the rotation into value, moving away from companies with little cash flow today and into companies with high cash flow today.

Smash cut. Next point.

4) Past performance is not indicative of future returns. In fact, the opposite is frequently true. It’s mean reversion. Crashes rebound and price booms crash. Looking at the Nasdaq, you can run a regression trend from any point from the bottom of the financial crisis until today and see that the Nasdaq is 3 standard deviations away from the mean. Everyone talks about the financial crisis as a black swan. A 3 standard deviation drop in the market. People don’t seem all that concerned that we just went through another black swan event. Reverting to the mean would mean a 30+% drop. Other indications things are overvalued: Buffett Indicator and Schiller PE (aka cyclically adjusted PE ratio)

Lastly -

5) Sentiment. Be fearful when others are scared and scared when others are fearful. Looking at chatter in various subreddits, you can see people recommending ARK ETFs, triple leveraged ETFs, yolo in options, yolo on GME, Bitcoin, etc. Anyone who thinks these are good investments has already bought. Everyone knows about them. There are few, if any, new buyers needed to lift these to new highs.

All of this doesn’t mean a crash is imminent. Markets can stay irrational longer than you can stay solvent. Things could take years to play out. Policies can change and so can the economy. All I’m saying is perhaps a little more caution is warranted. Maybe take a little money off the table. Things could get bumpy.