What Will It Take to Kill This Bull Market? We’ll Find Out Soon.

What Will It Take to Kill This Bull Market? We’ll Find Out Soon.

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Shopping for produce in New York City in December.
Ed Jones/AFP via Getty Images

Insurrection, infections, and inflation are what 2021 will be remembered for. But none of them seemed to matter for U.S. common stocks, or at least as much as some might have thought. Once again, the best thing for investors to have done would have been to turn off their computers, phones, and (especially) TVs, and set and forget their portfolios.

The stock market would have amply rewarded those who closed their eyes and rode out the year in the large-capitalization indexes. For that, they would have been rewarded with a 25.52% total return in the SPDR S&P 500 exchange-traded fund (ticker: SPY) from the beginning of 2021 through Wednesday, according to Morningstar. (We’ll look at ETF returns since that’s how most folks are playing along at home.)

Going outside of the large-capitalization benchmark mostly wasn’t worth the trouble or risk. Small-caps trailed with less than half their big brethren’s return, with a 12.34% year-to-date return on the iShares Russell 2000 ETF (IWM). Venturing abroad didn’t pay either, with the Vanguard FTSE All-World ex-US ETF (VEU) returning just 6.32%. Credit (or blame) less-developed markets; the iShares MSCI Emerging Markets ETF (EEM) suffered a negative 4.87% return, and the iShares MSCI China ETF (MCHI) took a 22.02% hit.

Bonds didn’t pay, either, with the iShares Core US Aggregate Bond ETF (AGG) returning a negative 1.63% year to date, though the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) managed a positive 3.35%. But our income investment pick for 2021, closed-end leveraged loan funds, nearly kept pace with stocks. For example one fund, the Nuveen Floating Rate Income Opportunity (JRO), returned 23.34%—with less risk than equities.

Inflation, like Hemingway’s famous observation about bankruptcy, started the year gradually and came on suddenly. Heading into 2021, consumer prices were rising at only a 1.4% year-over-year rate, the result of the deflation wrought by the crash of prices as the economy collapsed after the onset of Covid-19 earlier in 2020, and far below the Federal Reserve’s long-run target of 2%. Back in January, the lynx-eyed Peter Boockvar, chief investment officer at Bleakley Advisory Group, began warning of supply tightness driving up a wide range of goods prices, from commodities to DRAM chips.

By the autumn, supply-chain kinks were all over the evening news, with the weakest links seemingly at ports where stacks of containers with imported goods waited to be loaded onto trucks, which, along with drivers, were in short supply. And inflation was soaring at a rate not seen in a generation, with the consumer price index up 6.8% from a year earlier, the fastest since 1982.

Supply tightness was only part of the problem. Another fiscal package totaling $1.9 trillion from the incoming Biden administration—on top of the $900 billion package and the $2.1 trillion Cares Act passed the year before—was being pumped into the U.S. economy. Crucially, the Fed was supporting the fiscal borrowing by purchasing Treasury securities at nearly a $1 trillion annual rate, along with nearly $500 billion in agency mortgage-backed securities to help spur housing.

Added together, James Paulsen, the Leuthold Group’s chief investment strategist, observed in January, money supply growth was running four times as fast and the federal deficit was four times as big as the last time the labor market was at a similar level. All of which amounted to “too much cowbell,” as in the classic Saturday Night Live sketch, which portended much higher inflation.

Where the resulting inflation showed up—but isn’t directly counted in the price indexes—is in housing. Early in the year, Fed Chairman Jerome Powell called the new double-digit surge in home prices a “passing phenomenon” related to the pandemic sending young families fleeing city apartments for single-family houses with room enough to work from home.

By September, however, house prices were soaring at nearly a 20% rate, according to the CoreLogic Case-Shiller indexes’ most recent reading. But, as former AllianceBernstein chief economist Joseph Carson pointed out late last month, owners’ equivalent rent (the convoluted way housing costs get counted in the CPI) was up less than 3% from a year ago.

There’s typically a lag of six to 12 months before this measure of rents catches up with soaring home prices, he observed. By then, he added, owners’ housing costs, which account for nearly one-quarter of the overall CPI, will lift retail prices far more than the widely noted spurt in used-car prices last spring.

Home prices weren’t the only thing popping. The year now ending will be remembered for manic speculation in what came to be known as meme stocks touted on internet venues such as Reddit. With betting on sports curtailed by the coronavirus, punters turned their gambling to companies distinguished mainly by the bets placed against them. And staked with “stimmies,” the stimulus checks from Uncle Sam, free phone trading apps, and a surfeit of free time, these self-described “apes” sought to take on the big, evil short sellers.

Whatever the motivation of the sans-culotte speculators, the source of much of their stake is the U.S. Treasury, which borrowed the money at about the lowest interest rates in recorded history, a result of the U.S. central bank fixing the cost of money at zero. In real terms, that is, after stripping away inflation, it’s far less than zero—below negative 1% for 10 years.

It’s an axiom of finance that a low cost of money pumps up the value of assets. The present value of an investment’s future cash flows goes up as the interest rate to finance that investment goes down. Cheap, abundant capital can justify all manner of wild and wonderful investments, from electric vehicles to stationary bicycles with tablet computers attached to cryptocurrencies of no intrinsic value that can fluctuate 20% over a weekend.

Besides the seemingly never-ending effects of the pandemic, the signal aspect of 2021’s financial markets has been the power of money, conjured and created by central banks. It has accommodated borrowing by governments on a scale never experienced in peacetime and pumped up asset values to records. And it’s having the same effect on the prices of what’s being purchased, which has put inflation at the top of the worry list of the public and politicians.

Next year, some of that process will begin to reverse. Printing less money may slow the process of pumping up prices, but the impact is apt to be uneven. It may well affect prices of securities first, then prices of goods and services. And the way down is likely to be less pleasant than the way up.

Read more Up and Down Wall Street:Omicron Is Surging. Inflation Is Rising. But Investors Are Dreaming of a Santa Claus Rally

Write to Randall W. Forsyth at randall.forsyth@barrons.com

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