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The Dry Powder That Will Keep Markets Rising in 2021
Posted by Ted Bauman | Jan 4, 2021 | Bauman Daily, Stocks, U.S. Economy
4 minute, 41 second read
I bet many investors — me included — woke up on January 1 and asked themselves, "What the heck just happened?"
I'm not talking about New Year's Eve excess.
I'm talking about the year gone by.
Amid a deadly global pandemic, the U.S. economy suffered one of the biggest and fastest declines in history. Second-quarter gross domestic product (GDP) dropped by 32.9%.
The stock market followed suit. The S&P 500 collapsed, losing 31% between February 19 and March 23. But then it bounced back, recovering 67% from that low by the end of the year.
The economy, not so much. Although fourth-quarter figures aren't in yet, projections suggest a 3% decline in GDP for the year.
There's no shortage of theories on how the stock market and economy could behave so differently. I've sifted through all of them.
My conclusion is the stark disconnect we saw last year is due to a surprisingly simple factor … one that could play a monumental role in this year's stock market.
Irrational Expectations
The most common explanation for the big divergence between the stock market and the real economy is that financial markets are forward-looking. GDP reflects real-time economic activity. The stock market reflects what investors think will happen in the future.
In a perfect world — the one where academic economists live — stock prices instantly reflect all available information about the future. Prices can only be "wrong" if that information is incomplete.
In the real world, everything depends on who's acting on that information, and how much analytical firepower they can bring to bear on it.
This first chart shows the buying and selling activity of big institutional investors like hedge and pension funds.
After the March 23 low, stock purchases rose rapidly. But these institutional investors quickly backed off. For the rest of the year, they remained net sellers of stocks:
Yet stock prices kept rising.
That's because small retail investors piled into the market in a big way.
This next chart shows the volume of call options activity.
After declining in the second quarter, it skyrocketed to all-time highs for the rest of the year.
Investors were buying stocks as well, of course. But call options have a powerful indirect impact on stock prices because sellers of those options need to buy the underlying stock as a hedge:
Putting these two together, my thesis is that, after the initial bargain buying in late March and April, institutional investors — the ones with access to the best information about the future, and the resources to analyze it — backed off.
But retail investors kept pumping money into the stock market, buoying prices for the rest of the year.
Stimulus to the Rescue
As anybody who frequents the comment section on my YouTube channel knows, many retail investors have a high opinion of their own investing skills.
The fact is that most of them are playing AAA ball at best.
The big Wall Street houses are the all-star team.
Some of last year's retail enthusiasm for stocks reflects the spectacular gains to those who jumped in at the bottom in the second quarter. A success like that encourages investors to go for more.
But, as in any market, the desire to buy something is only effective if you have the money to do it. And in 2020 a lot of people had a lot of extra money.
The chart below (from Nate Silver at The New York Times) shows income lost due to the pandemic compared to increases in income from other sources. Adding together unemployment, stimulus checks, the paycheck protection program and other income, Americans enjoyed an astounding $1 trillion increase in personal income during 2020:
At the same time, Americans spent $535 billion less on services and interest payments than in a normal year. That was offset somewhat by an increase in expenditure on durable goods, but overall, Americans cut spending massively in 2020:
Putting the two together, Americans increased their personal savings by $1.56 trillion in 2020, a 173% jump over 2019:
Here's the thing: Personal savings is simply the statistical difference between income and expenditures. Not all money went into bank accounts or under mattresses. A lot of it was used to buy stocks in a brokerage account.
And there's no question that a big chunk of the stimulus money paid out by the federal government last year went into the stock market, where it pushed up prices.
One important piece of indirect evidence for this is the behavior of asset prices in the fourth quarter. The top three performing asset classes — bitcoin, special purpose acquisition companies (SPACs) and initial public offerings (IPOs) — were the riskiest.
With all due respect to bitcoin investors and to the hopes of those who bought into SPACS, no tangible assets back either of those investments. They reflect pure speculative hope — the hallmark of the poorly informed retail investor:
Of course, not all of 2020's excess personal income was spent. A lot of it remains in bank accounts and revolving credit facilities.
That's a lot of dry powder ready to fire in 2021 when the signals are right for hitherto-hesitant retail and institutional investors.
The big questions are:
1. What will those signals be?
2. What stocks are they going to buy?
Those are the two most important questions to keep asking in the coming months.
The Bauman Letter and Profit Switch are going to be looking for the answers every waking moment.
And you can reserve your seat now to be first in line to discover Clint Lee's groundbreaking Flashpoint Fortunes strategy for 2021 this Thursday.
Editor, The Bauman Letter
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