The essence of market economies is that millions of individuals making profit-oriented decisions, for the benefit of themselves, their families and communities, will allocate resources significantly more efficiently than government bureaucrats making the same decisions on behalf of millions of individuals. One of the key reasons is everyone’s circumstances are different and can therefore make decisions appropriate for themselves.
What happens, however, when a resource becomes exceedingly cheap? Are we as judicious with a cheap resource as an expensive one? Clearly, cheap resources have a higher probability of being wasted than expensive resources.
I have a recollection from the 1960s when my dad was trying to teach me about interest rates. He informed me that if you took money to the bank, they would keep it safe and pay a little in the way of interest. I was somewhat perplexed and asked, “If they are storing your money and keeping it safe why don’t we have to pay them?”
A generation later, in many parts of the world, you now have to pay the bank to keep your money safe, with about one-quarter of government bonds worldwide having negative rates. Even Greece, that bastion of financial stability (not), issued a negative rate bond.
Money has reached an unprecedented level of cheap, and things that are cheap can be wasted. If individuals are prone to wasting cheap money, governments are more susceptible given they borrow at the best rates and can print whatever they can’t raise from the market or taxes.
Cheap money and government largesse are why I believe speculations have run rampant. Bitcoin and many speculative stocks have exploded. The word “bubble” is being used regularly to describe the stock market. Yet many stocks are reasonably priced with more than five per cent earnings and free cash flow yields.
Therefore, I would suggest the markets are not in a bubble, but many stocks are. On a forward-looking basis, the largest 10 S&P 500 companies, representing an amazing 28 per cent of the total market capitalization, have just a three per cent earnings yield. The remaining 490 companies representing 72 per cent of the market cap have a 66 per cent higher earnings yield of five per cent. So, 490 companies in aggregate are reasonably priced.
The last time the market was this distorted was in 1999. For three years afterwards, the average annual performance of the TSX and S&P 500 were 0.1, -13.5 and -17.9 per cent. Yet our RRSP average performance was 19.5, 4.6 and -5.5 per cent. Sticking with money-making companies, rather than speculating on the latest hot stock paid off handsomely.
For the last decade, the United States has trounced Canadian market performance. The following are the S&P 500 total returns minus the TSX total returns for the last 10 years starting in 2011: 10.8, 7.8, 20.9, 3.1, 9.7, -8.2 (2016 was the only year the TSX outperformed), 13.5, 4.5 (both were negative but the United States less so), 8.6 and 12.8 percentage points.
Considering these factors, and as a follow-up to the, “He who lives by the crystal ball will eat shattered glass” article, here are my 2021 market predictions for those interested in dining on such a delicacy. These were written while experiencing my annual January 1 hangover, although it was a milder lockdown version:
1. Most predictions will be wrong.
2. I have pegged the S&P 500 to be flat to up modestly, perhaps five per cent. There are too many companies with too high a valuation on the S&P. However, no one knows when the bubble on these will burst, just that it will. Many predictions are more bullish, contributing to my conservativeness.
3. I called for the TSX to finally outperform with an increase in the teens, percentage-wise. I remain optimistic on commodities.
4. While the intelligentsia thinks inflation will remain low, I called for it to close out the year about three per cent.
Another factor to consider is that interest rates have doubled since the summer. But two times nothin’ is still nothin’! In fact, U.S. 10-year bond rates have increased from 0.52 to 1.08 and Canadian rates have moved from 0.43 to 0.79 per cent. For clarification, the government sets the overnight short-term rates, but the market sets long-term rates.
One thing to keep in mind is when widgets are cheap, and a few are wasted, it’s not such a big deal. However, when money is cheap and it’s wasted, it still must be paid back!