May 2021

The Manley Macro Memo

The S&P 500 reached a record high in April due to strong economic data and the Fed's commitment to not remove any of their emergency monetary measures for the foreseeable future.


Executive Summary

The market rally continued in April. Strong economic signals, the Fed's commitment to keep interest rates low, and the successful vaccine rollout led to a 5.3% rally and a record high for the S&P 500.

Although the April economic data was robust, interest rates declined for the month. The U.S. 10-year Treasury bond dropped by 0.12% to close the month at 1.63%. This modest drop in interest rates helped growth stocks outperform value stocks for the first time in 2021. This countertrend rally is not surprising since the Russell 1000 Value Index outperformed the Russell 1000 Growth Index by the most in twenty years in the first quarter.  As the economic recovery gains momentum, we expect inflation and interest rates to move higher and the economically sensitive value stocks (financials, industrials, materials, and energy) to outperform the interest-sensitive growth sector.

Despite the surging stock, commodity, and housing markets, the Fed Chairman Powell smugly said the Fed was not yet "talking about talking about" tapering their emergency policies because the jobs market is in a huge hole, and any inflation is transitory. Not all experts agree with the Fed. In fact, Larry Summers, President Clinton's Treasury Secretary, said this "is the least responsible macroeconomic policies we've had in the last 40 years," and by misreading the economy, the Fed created a "dangerous complacency" in the financial markets. 

Although the Fed seems unconcerned about the unintended consequences of their policies, we believe that financial markets could be at risk in the second half of the year, as inflation surges and the Fed is forced to tighten monetary conditions abruptly. Currently, there are significant commodity shortages, and prices are surging, yet the European Union (the second-largest economy behind the U.S.) remains essentially closed because they struggled to contain the virus and roll out the vaccine. As Europe becomes vaccinated and their economy reopens this summer, the global economy and inflation are poised to surge.  We will continue to invest in the value sectors of the market (financials, industrials, materials, and energy) and commodities that will benefit from the global economic surge.

Since the March 2020 pandemic market low, the S&P 500 has appreciated an incredible 92.4%. Unfortunately, most of this rally was due to a record increase in market valuation. According to Factset, the forward 12-month P/E ratio for the S&P 500 is 21, which is 31.2% above the 10-year average of 16. By most valuation measurements, the market has never been more expensive. We believe that this extreme overvaluation will yield muted gains and create a poor risk-reward for equities over the long term.


Market Discussion:

The market rally continued in April. Strong economic signals, the Fed's commitment to keep interest rates low, and the successful vaccine rollout led to a 5.3% rally and a record high for the S&P 500. While the S&P 500 had its best month since November, the small-cap Russell increased by only 2.1%. Additionally, the MSCI EAFE Index (international large and midcap stocks ex-U.S. and Canada) and the MSCI Emerging Markets Index rose by 3.0% and 1.3%, respectively.  Despite the equity market's strength, the safe havens performed well, the U.S. long-bond rallied by 2.4%, and Gold appreciated by 3.6%.

Although the April economic data was robust, interest rates declined for the month. The U.S. 10-year Treasury bond dropped by 0.12% to close the month at 1.63%. This modest drop in interest rates helped growth stocks outperform value stocks for the first time in 2021. This countertrend rally is not surprising since the Russell 1000 Value Index outperformed the Russell 1000 Growth Index by the most in twenty years in the first quarter.  As the economic recovery gains momentum, we expect inflation and interest rates to move higher and the economically sensitive value stocks (financials, industrials, materials, and energy) to outperform the interest-sensitive growth sector.

Since the March 2020 pandemic market low, the S&P 500 has appreciated an incredible 92.4%. Unfortunately, most of this rally was due to a record increase in market valuation. According to Factset, the forward 12-month P/E ratio for the S&P 500 is 21, which is 31.2% above the 10-year average of 16. By most valuation measurements, the market has never been more expensive. We believe that this extreme overvaluation will yield muted gains and create a poor risk-reward over the long term, especially as interest rates begin to normalize.

Stocks rallied in April because of the strong economic data and the Fed's commitment to not remove any of their emergency monetary measures for the foreseeable future. In addition to indicating that they will not increase interest rates before 2023, Fed Chairman Powell said the Fed was not yet "talking about talking about" tapering their Quantitative Easing program that prints $120 billion each month to buy bonds. According to Federal Reserve Bank of Minneapolis President Neel Kashkari, "We are still somewhere between 8 and 10 million jobs below where we were before the pandemic," and since the labor market is in a "deep hole," aggressive monetary support is necessary.

While the economic data reported in April was unequivocally good, May's reported economic data was disappointing and, in our view, demonstrates significant policy errors.  After creating 916,000 jobs in March, economists forecast that the economy would produce more than one million jobs in April. Unfortunately, only 266,000 jobs were made, and March's robust number was revised significantly lower.

While the Fed and many pundits believed the weak jobs number validates their aggressive monetary policy, we think it is the unintended consequence of bad fiscal policy. In March, despite the recovering economy, the federal government extended their enhanced jobless benefit, which increases unemployment benefits by an additional $300 per week, and in many cases, incentivizes (or pays) workers to stay home.

The Fed believes that the labor market is in a "deep hole," yet they are ignoring this disincentive to work and the significant labor shortages across many sectors of the economy. We expect the labor market to surge this summer because 22 states recently stated that they would stop distributing the $300/week in extra unemployment benefits to address the concern of labor shortages.

After the weaker-than-expected jobs report, economists were again surprised the following week when the BLS reported that inflation jumped by 4.2% from a year earlier, which was the most significant increase since 2008.  The Fed was not concerned about this jump in inflation since they believe that any increase in inflation is "transitory" due to the easy base effects (artificially low comparisons due to last year's economic shutdown).

Chart 1: CPI Inflation jumped by an unexpected 4.2% in April. While the Fed believes this increase is "transitory," supply chain problems, booming equity, housing, and commodity markets may indicate that the Fed-induced a financial bubble.

Source: FRED.com

According to famed economist Milton Friedman, "Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output." Over the past twelve months, the Fed has increased the quantity of money by 24%, which is the most significant increase in post-WWII history. We believe that this profligate increase in the money supply, not the base effect, is responsible for the inflationary surge and booming asset prices (stocks, housing, and commodities).

Chart 2: To combat the economic shutdown, the Fed has increased the money supply by a historic amount. We believe higher inflation and asset bubbles are the unintended consequence of the Fed's reckless monetary policy.

Source: FRED

Chart 3: The Fed's emergency monetary measures and surging inflation produced the lowest real interest rates since 1980. Since monetary policy acts with a lag, inflation could become a significant headwind for investors.

Source: FRED.com

Despite the surging stock, commodity, and housing markets, the Fed Chairman Powell smugly said the Fed was not yet "talking about talking about" tapering their emergency policies because the jobs market is in a huge hole, and any inflation is transitory. Not all experts agree with the Fed. In fact, Larry Summers, President Clinton's Treasury Secretary, said this "is the least responsible macroeconomic policies we've had in the last 40 years," and by misreading the economy, the Fed created a "dangerous complacency" in the financial markets.

The housing market is another example of the Fed's reckless monetary policy. Housing prices have increased by 12% over the past year to a record high, and home prices relative to income are approaching the extreme level of the 2006 housing bubble. Although the housing market is booming, and many home buyers are being priced out of the market, the Fed is printing $40 billion each month to buy mortgages and stimulate the overheating real estate market.

Chart 4: The Fed is buying $40 billion of mortgages each month to reduce mortgage rates and stimulate the booming housing market artificially. Incredibly, the Fed indicated that they haven't yet talked about tapering their extreme monetary policy.

Source: Longtermtrends.net

Currently, there are significant commodity shortages, and prices are surging, yet the European Union (the second-largest economy behind the U.S.) remains essentially closed because they struggled to contain the virus and roll out the vaccine. As Europe becomes vaccinated and their economy reopens this summer, the global economy and inflation are poised to surge.

Although the Fed seems unconcerned about the unintended consequences of their policies, we believe that financial markets could be at risk in the second half of the year, as inflation surges and the Fed is forced to tighten monetary conditions abruptly. While the Fed is focused on convincing the financial markets that they won't tighten despite strong growth and inflation, investors are becoming more cautious. Many speculative areas of the market have peaked and are in sharp corrections. This narrowing of market breadth typically presages a more significant market correction.

Chart 5: While the S&P 500 is near a record high, areas of excessive speculation (IPO's, SPAC's, FANG's, Small caps, and Bitcoin) are in a correction and underperforming.

Source: FRED.com

In summary, the S&P 500 rallied to a record high because of the successful vaccine rollout, the surging growth due to the reopening of the economy, and the massive monetary stimulus. We are concerned that financial markets will be vulnerable as the global economy surges and the Fed is abruptly forced to tighten monetary policy. We will continue to invest in the value sectors of the market (financials, industrials, materials, and energy) and commodities that will benefit from the global economic surge.



Sector Review:  All eleven sectors of the S&P 500 appreciated in April. The leading sectors were REITs, Communications, Discretionary, and Financials. The laggards were Energy, Staples, and Industrials. We expect the value sector of the market (financials, industrials, and materials) will continue to outperform in this reflationary economic environment.


Our Model Portfolio:

The benchmark for our model portfolio is the Traditional Blend — 60% equity, 40% bonds. Our goal is to outperform the benchmark with less risk. To outperform, our investment portfolio is diversified and economically balanced. We eliminate laggards and tilt the portfolio toward our location in the business cycle. Finally, we risk-weight our positions to manage volatility.

We remain positioned for a reflationary economic environment (accelerating growth and inflation). We are concerned that significant monetary and fiscal policy errors could lead to an inflation problem in the second half as the global economy accelerates. The portfolio is invested in the economically sensitive sectors of the market (industrials, financials, and energy), commodities, and TIP's (U.S. Treasury Inflation-Protected Securities) that should benefit in a period of accelerating growth and inflation. Our portfolio's annualized volatility is 13.5%, which is slightly riskier than our benchmark.

Current Risk-Weighted Portfolio:


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Our short-term (three-months) outlook is neutral:

We believe that the market offers a poor short-term risk-reward because stocks are overbought, investors are complacent, and market breadth is deteriorating. While the S&P 500 closed at an all-time high on May 7th, the speculative sectors of the market (SPAC's, IPO's, ESG, Bitcoin, and small caps) are in a correction. Narrowing market breadth typically presage a market correction. After the market's record run, we believe that a correction to reduce the excesses would be healthy. When investors are fearful, the market is oversold, and breadth begins to improve, we expect to increase our tactical risk exposure. Our short-term market outlook is neutral.


Our long-term (more than four years) outlook is neutral:

We believe that the S&P 500 offers a poor risk-reward because it is extremely overvalued. Also, we are concerned about the long-term unintended consequence of the unprecedented monetary and fiscal policy that was used to combat the pandemic.  Artificially low-interest rates and historic peacetime deficits have led to a record debt burden, which will become problematic as the economy grows, and interest rates normalize.

Over the next few quarters, we continue to see a significant opportunity to invest in the value sectors of the market while avoiding the mega-cap tech and the S&P 500. While we expect to profit from the reflationary rotation into the cyclical stocks, longer-term, we remain concerned about the impact rising interest rates will have on stock valuations. Our Strategic Asset Allocation is underweight equities relative to our benchmark.


Disclaimer: The material in this newsletter is for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. This newsletter is not a substitute for professional investment services. Past performance is no guarantee of future results, and there is no assurance that investment objectives will be achieved. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. All investments contain risk.

Sincerely,

By: Manley Capital Management, LLC


J. Lawrence Manley, Jr., CFA
Managing Member


About the Author

J. Lawrence Manley, Jr., CFA has always had a passion for investing and has been lucky enough to spend nearly 25 years managing investment portfolios for pension funds, endowments and high-net-worth families. In his experience, there are two major obstacles preventing individuals from reaching their investment goals: Wall Street and Human Nature. Manley Capital was founded to overcome these obstacles and partner with clients to achieve their financial goals.