April 2021

The Manley Macro Memo

The Successful Vaccine Rollout and Better than Expected Growth Drove the S&P 500 to a Record High in March


Executive Summary

The S&P 500 surged to a record high in March, fueled by the successful vaccine rollout, massive monetary and fiscal policy, and better than expected growth due to the fiscal stimulus and the reopening economy.

Strong economic growth and rising inflation expectations drove the 10-year U.S. Treasury bond to 1.74%, which increased by 0.85% in Q1. In this period of rising interest rates, growth stocks struggled, while value stocks thrived. The Russell 1000 Value Index rose by 10.7% in Q1, while the Russell 1000 Growth Index increased by only 0.70% -- this was the value sector's largest outperformance in twenty years.  As the economy recovers, we expect interest rates will continue to rise, and the economically sensitive value stocks will continue to outperform the interest-sensitive growth sector.

The Fed's policy of financial repression (0% interest rates, negative real rates, and printing money to buy bonds) and their promise to not raise interest rates until 2023 has created a debt-fueled financial mania. Margin debt has increased by more than 70% over the past 12 months and is a record percentage of GDP. Historically, periods of excessive speculation and record leverage have not ended well.

According to Factset, the forward 12-month P/E ratio for the S&P 500 is 22.5, which is 41.5% above the 10-year average of 15.9. 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.


Market Discussion:

The S&P 500 surged to a record high in March, fueled by the successful vaccine rollout and better than expected growth due to the fiscal stimulus and the reopening economy. The S&P 500 rallied by 4.5%, while the small-cap Russell rose by1.0%. The MSCI EAFE Index (international large and midcap stocks ex-U.S. and Canada) rallied by 2.5%, while the MSCI Emerging Markets Index fell 0.7%. The safe havens again performed poorly, the U.S. long-bond dropped by 5.3%, and gold fell by 0.8%. Our traditional benchmark (60% stock, 40% bonds) increased by 2.25% in March.

During the first quarter, the economy showed signs of significant strength. There were 916,000 jobs created in March, and retail sales jumped by 9.8% compared to February and were nearly 28% higher than the pandemic low last March. The manufacturing sector was also very strong in March. The Institute for Supply Management stated that its PMI manufacturing index was the strongest since December 1983.

Chart 1: The ISM Purchasing Manager's Index reached 64.7, which was the highest reading since December 1983, and is consistent with very strong economic growth.

Source: Tradingeconomics.com

Strong economic growth and rising inflation expectations drove the 10-year U.S. Treasury bond to 1.74%, which increased by 0.85% in Q1. In this period of rising interest rates, growth stocks struggled, while value stocks thrived. The Russell 1000 Value Index rose by 10.7% in Q1, while the Russell 1000 Growth Index increased by only 0.70% -- this was the value sector's largest outperformance in twenty years. As the economy recovers, we expect interest rates will continue to rise, and the economically sensitive value stocks will continue to outperform the interest-sensitive growth sector.

Since the March 2020 Pandemic-low, the S&P 500 has been on a historic run. 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 22.5, which is 41.5% above the 10-year average of 15.9. By most valuation measurements, the market has never been more expensive (see table below).  We believe that this extreme overvaluation will yield muted gains and create a poor risk-reward over the long term.

Source: Goldman Sachs

In addition to the successful vaccine rollout, the fiscal stimulus, and the strong economic data due to the economic reopening, stocks were driven higher in Q1 by the Fed's profligate monetary policy. To combat the pandemic and economic shutdown, the Fed reduced short-term interest rates to 0% and "printed" $120 billion each month to purchase bonds and inflate risk assets. Despite the recent economic recovery and the record high stock market, the Fed continues its unprecedented monetary policies and has promised not to raise interest rates until 2023. 

Additionally, in March, the Fed stated that they would switch to an "outcome-based guidance" instead of relying on their economic forecasts to adapt monetary policy. This change from a proactive to reactive monetary policy is an attempt to convince the financial markets that they will not remove their unprecedented level of monetary stimulus too soon.

In our view, the Fed's radical promise to not remove any of the emergency monetary measures for the foreseeable future has led to excessive speculation and an unhealthy amount of margin debt (see chart below). The Fed's actions have destroyed the market's price discovery mechanism and turned markets into casinos where participants borrow and gamble on short-term outcomes rather than invest for the future.

The Fed's policy of financial repression (0% interest rates, negative real rates, and printing money to buy bonds) and their promise to not raise interest rates until 2023 has created a debt-fueled financial mania. Margin debt has increased by more than 70% over the past 12 months and is a record percentage of GDP. Historically, periods of excessive speculation have not ended well.

Chart 2: Margin Debt has surged since the Fed-induced March low. Similar surges in margin debt have preceded significant market tops.

Source: Advisor Perspectives

Chart 3: Margin Debt is at a record high relative to GDP.

Source: Gurufocus.com

Also, the Fed-induced euphoria has drawn the public into the stock market at a record rate. According to BofA Securities, Inc., inflows into the stock market over the past five months have exceeded the prior 12 years.

Source: Bank of America

While some may believe that the record inflows into the market are a positive, it is typically a cautionary sign of excess speculation. In fact, Merrill Lynch's legendary strategist, Bob Farrell, had 10 Rules for Investing, and Rule #5 was that the public buys the most at the top and the least at the bottom.

In summary, stocks have rallied to record highs because of the successful vaccine rollout, massive fiscal stimulus, and the surging growth due to the reopening of the economy. While the economic fundamentals should remain strong, the Fed's profligate monetary policy has encouraged speculation and excessive leverage, which, in our view, will lead to market instability. As value investors, we will avoid the speculative sectors of the market and continue to make investments with positive risk rewards.



Sector Review: All eleven sectors of the S&P 500 appreciated in March. While the cyclicals (financials, industrials, and materials) continued to outperform, it is interesting to note the strong performance of the market's defensive sectors. Strength in the defensive sectors of the markets often presage a market correction, but since the safe havens (U.S. long-term bond and gold) continue to act poorly, the defensive's rally is likely a counter-trend move.


Our Model Portfolio:

In March, we slightly underperformed our 60/40 benchmark but continue to outperform on a year-to-date basis while assuming less equity risk. Our performance was driven by our investments in the cyclical sectors of the market: Industrials (9.0%), the MSCI Value Factor (+7.3%), the Alerian MLP (+7.2%), and the Financials (+5.9%). Our laggards in the portfolio were negatively impacted by the U.S. Dollar's counter-trend rally: MSCI Emerging Markets (-2.4%), the GSCI Commodity Index (-1.9%), Gold (-1.2%).

We remain positioned for a reflationary economic environment (accelerating growth and inflation). As we become vaccinated and the economy reopens, the growth should continue to accelerate as consumers spend their pent-up savings. We expect the strong growth will continue into the second half of the year.  We are overweight the economically sensitive sectors of the market (industrials, financials, and energy) and have exposure to the international and emerging markets, which are inexpensive and should benefit from a weak dollar.



Our Current Risk-Weighted Portfolio:

Our portfolio is positioned for a reflationary economic environment (accelerating growth and inflation). We are underweight equities and fixed income and overweight commodities relative to our benchmark. In aggregate, our portfolio is about 20% overweight the benchmark's risk level.


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

The S&P 500 has rallied nearly 30% since the October vaccine market low. We believe that the market offers a poor short-term risk-reward because it is very overbought, investors are euphoric, and signs of irrational speculation are occurring daily. While the S&P 500 closed at an all-time high last week, the speculative sectors of the market (SPAC's, IPO's, ESG, Bitcoin, and small caps) are in a correction, and market breadth has deteriorated, which typically presage a market correction. After the market's record run, we believe that a correction to reduce 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.