Since March, many people started to worry about the risk of a potential stock market crash. People are rightfully fearing high stock market valuation and inflation risks. The current P/E ratio of S&P 500 is nearly 30 and Nasdaq’s PE is at 88, this is a level that is above the long-term average. Nevertheless, I wrote an article titled “optimism is the virtue of capitalism” in my last month’s reflection. Despite the heightened volatility and possible corrections from time to time, I believe the stock market will end in 2021 positive.
As we have witnessed so far, the renewed virus variant and new lockdowns have little impact on the stock market. I believe the market is driven by “animal spirits” now. Investor’s behaviours are driven by emotional confidence rather than the traditional financial matrix. This means monetary and fiscal policy changes and politics will have a greater impact to boost or dampen the market sentiment. And sentiment will be the key driver of the market movement for the second half.
Animal Spirits – Emotion, not valuation are driving the markets
Animal spirits come from the Latin “spiritus animalis”, which means “the breath that awakens the human mind.” It was coined by British economist, John Maynard Keynes in 1936.
Animal spirits refer to the ways that human emotion can drive financial decision-making in uncertain environments and volatile times. This happens to echo the key ideas behind the GMC investment principle, that the role of emotion and herd mentality plays a very important part in investing.
We can see how the investors’ confidence level affects the stock market performance. Let me give you some examples.
The US never really went to a complete lockdown and not everybody wears a mask. And now their government asks people to go back to normal life and stop wearing masks. As dangerous as it sounds, the US is the “best place to be” based on Bloomberg’s Covid Resilience Ranking now.
When the global pandemic just hit the US, they reduced the interest rate to zero and unleashed unlimited Quantitative Easing. They even “bent the rule” to directly buying corporate bonds to support the market. In such an environment, investors are naturally optimistic about the future and are willing to invest for the future.
Chinese governments are paranoid about the “asset bubble”. The “national teams” repeatedly intervened in the stock market whenever it became overbullish. They are in full force to deleverage by targeting the property developers for the real estate market. On the innovation side, instead of promoting the tech giants to be a new global leader, they are focusing on anti-trust laws to break the big techs and now they are even targeting the tuition industry. Even a hardcore long term China investor like me can feel discouraged to invest in China right now.
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I have been overweighing China since 2 years ago and this has served my portfolio well. I have hoped China will take this crisis to expand their capital markets and global reach, but it seems to me that the policymakers are having a different agenda.
China was the first major country to recover from the pandemic but it seems the growth momentum is slowing down, worsening by tightening monetary and fiscal policies. I understand the policies are for long term sustainability and financial market integrity. But as an investor, we have to optimise the use of our capital. Given the USA’s political push, the global sentiment towards China is also not favourable now. We have already seen huge institutional funds flowing out of China.
COVID-19 caused a crisis, but also created a lot of opportunities. How many new millionaires and billionaires are created in the past year? How many new startups and new economies emerged?
Think about the new technologies and industries that attracted trillion dollars of capital such as blockchain, electric vehicles, renewable energies; think about the rebooted old sectors such as semiconductors, logistics, oil and gas. How much did Singapore benefit from these? Or are we just “surviving”?
When Covid just hit the global economy last year, Singapore withdrew an unprecedented amount of national reserves to support the country. Companies and mortgage payors are allowed to defer their loan repayment. While I applause for the swift action and good intention, I was concerned that the new liquidities will be sucked by the “zombie companies” and property market.
Additional Reading: Is Singapore spending too much on national reserves?
If you do not allow bad companies and imprudent property investors to fail, they will just hoard the resources which could have been used for innovation and new jobs.
True enough, Singapore’s private property index has reached a new high.
But at the same time, the Straits Times Index, which reflects Singapore’s economy, is still underwater while other major stocks indices have surpassed the pre-pandemic level.
In my earlier article, I quoted Winston Churchill famously saying “never let a good crisis go to waste”. In the past year, I have seen people who suffered from pandemics; but I also saw business people and companies emerge stronger.
Opportunties award those who are prepared.
Will the US dollar collapse?
With the increased popularity of Bitcoin and the concept of Defi (Decentralized Finance), the calling of a collapse of the US dollar is renewed. In my report to my clients earlier this month, I showed this chart below.
I said, “we need to pay attention to is the US dollar. I have a sense that the US dollar has hit the bottom and will appreciate (increase purchasing power) soon to cope with inflation.”
At that time, the dollar index just hit 90 and by now it has come back up to 92.
In my opinion, the Dollar will not and cannot collapse anytime soon. It is my wild guess that the US may raise interest rates sooner than they promise. The magnitude of the hike may be small but it is symbolic to kick start the global tapering. This is the scenario which we should prepare as it has a structural impact on the asset prices.
As I explained before, interest rates and inflation go hand in hand. If you recall, in Sep 2020, the US has set the average inflation target to be 2%. And the inflation shot up this year. I have mentioned before inflation is the “excuse” to raise the interest rate. Now the inflation target is on track, the Fed should and will raise the interest rate. The only matter is, when?
Where to invest if inflation really hits?
It is not apparent to many people how inflation will affect the financial markets because we are in low inflation and even deflation environment for too long.
I have talked about inflation since June last year. I said, “the only way for us to come out of the economic crisis due to the pandemic is through inflation”. But only recently the mainstream media start to talk big about inflation.
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I think the following will happen.
- Stage 1: inflation just started. It is good for value and stable dividend stocks as investors will rotate out of growth stocks due to poor future valuation. Bonds will be dumped as the low yield now is not able to compensate for the loss of inflation.
- Stage 2: inflation is at a medium level, the dividend incomes and stable returns from value stocks can no longer compensate for the loss of purchasing power due to inflation, thus people will look for high-quality companies which have the potential to continually grow in the long term.
- Stage 3: inflation reaches an unbearable level, all assets will crash, companies close down, people start losing jobs. The economy enters into a recession and the financial system will be reset.
You need to understand that when an investment topic is all over the news, it is often the end of the cycle. So I think we are approaching the end of Stage 1, and moving towards the medium level. There is a high chance that quality growth stocks will be back to favour.
In an inflation environment, you should position your portfolio with the assets that are “inflation passthrough”. However, it is also possible that inflation will ease in the near term as asset prices and commodities prices have somewhat overshot. Thus I believe that we should own both Value and Growth stocks at this moment and prepare for heightened volatility ahead.
This article reflects my personal opinion on the investment market and it is not investment advice. If you find it useful, share it and subscribe to my Telegram channel and mailing list below. Click here if you want to find out more about my investment management services.