Opinion: You dont have to be fully invested in the stock market today amid excess and speculation, says veteran investor Jim Stack
Since he called the 1987 stock market crash as a young analyst, Jim Stack has been one of the leading market contrarians.
Based in Whitefish, Montana, he pursues a safety-first approach in his Investech Research newsletter and in his money-management firm, Stack Financial Management, which manage $1.5 billion in assets. Stack has also been featured in Barrons list of top investment advisers.
When I interviewed him late last week, he was worried Wall Street wasnt paying enough attention to the many speculative excesses in the markets and the Federal Reserve was too complacent on inflation.
Howard Gold: In your latest issue of Investech Research, you said the Federal Reserve reversed its hawkish stance and started unwinding its interest rate hikes out of fear back in December 2018. Could you tell us how that may have set the stage for some of the things that have happened since?
Jim Stack: As were going into 2019, this economic recovery was already one of the longest economic recoveries in U.S. history. But the Fed had started raising interest rates, and the stock market took notice, and we had the worst December since the Great Depression. So the Fed immediately reversed and said, oh, well, we really didnt mean it and it wasnt long after that, that they started bringing interest rates back down again. And so, they brought the punchbowl back to the party and, particularly when the pandemic hit, they decided to add more and more alcohol to it, to where right now, I think theres a lot of participants on Wall Street investing like theyre a little bit inebriated, even as the PCE (Personal Consumption Expenditures price index), the Feds favorite inflation tool, goes way above their 2% target.
Gold: Where do you see inflation now, and how has the Fed policy affected that?
Stack: Were reemerging from a pandemic where everything was shut down and all of a sudden theres a very strong demand and a very poor supply chain. And those kinds of pressures the Fed has been arguing can be transitory. The problem is that a lot of the inflation pressures were seeing today are not transitory. [The Fed could not get the PCE] above 2%, except for several months, all the way from 2009 until this year, but all of a sudden, its gone right through the 2% threshold, up to 3.1%. I think it just recently hit 3.5%, and I think its also a lot stickier. The Atlanta Fed has come out with what they call a Sticky Price Consumer Price Index, and it includes goods and services that dont change in price very often. But when they do change, they continue to increase. These would be things like medical care, car insurance or alcoholic beverages. And this Sticky Price CPI has moved up to the highest level in 30 years. The Fed is going to get higher inflation. And I think the prices over the coming months are going to be on the upside. And thats where we could see trouble in a stock market that has become one of the most interest-rate-sensitive markets in history.
Gold: The bond market is not showing much fear of inflation. Weve seen the 10-year Treasury note for the last few weeks yielding between 1.45% and maybe a little over 1.5% and it peaked at around 1.76%. (It yielded 1.30% on Thursday.) So are bond investors wrong about this? Is it wishful thinking that they really cant see inflation coming?
Stack: I dont think Id call it wishful thinking; Id call it perhaps misplaced trust in the Fed, [which] has been trying to talk down inflation, trying to convince everyone that this is going to be transitory. And in the Fed meeting a couple of weeks ago, it was widely thought, theyre going to acknowledge that we are seeing some upside surprises on inflation, and theyre going to start at least putting a cap on the punchbowl and maybe stop the bond purchases. Instead, the Fed reiterated, were going to keep adding to that punchbowl out of conviction that this inflation was transitory.
And I think from our experience back in the 1970s, you have to live through those big inflationary cycles to find out how wrong or how far behind the curve the Fed can be. Thats my concern today: The Fed is being very convincing and I think thats what brought the bond yields down since that Fed meeting several weeks ago. I wouldnt be surprised if inflation is sticky, if we see upside surprises and if we see particularly strong employment reports, I wouldnt be surprised to see 10-year bond yields go back up and start pushing toward that 2% threshold.
Gold: How do you separate transitory price increases from sticky ones?
Stack: Housing costs and prices make up almost 40% of the CPI, and about half of that comes from owners equivalent rent [the amount ofrentthatwouldhave to be paid if an owners house were a rental property], which typically will track the price of housing. And we have seen one of the greatest increases in housing prices nationally over the past 12 months, at least going back to the high inflation period of the 70s. Rent follows those prices and that means that if anything, those numbers going into the owners equivalent rent and subsequently going into the CPI are going to surprise to the upside.
In 2005, we invented our Housing Bellwether Barometer, that told us were in a housing bubble because housing prices were 35% above the long-term inflationary trend. And sure enough, we were, and housing prices came down to, and actually a little under, that long-term inflation or CPI index. Well, today were over 43% above it. In other words, we have more of an upside disparity between housing prices and long-term inflation than we did in the housing bubble in 2005.
Gold: I interviewed the chief economist of Redfin who pointed out that the supply of homes is very, very low because older people are staying in their homes while you have pent-up demand from millennials who are now reaching home-buying age at the same time people are migrating out of cities following the pandemic. Are there special circumstances here?
Stack: Youre obviously seeing an influx of demand. We live in the Flathead Valley in Northwest Montana, and our housing prices have gone ballistic. And it seems that everyones quitting their job to become a realtor.
Gold: Thats an indicator for you!
Stack: It brings back all the memories of 2005-2006.
Gold: Are there bidding wars and all-cash offers in your neck of the woods, too?
Stack: Very much so. Youre seeing multiple offers above the asking price and thats happening in many high-demand areas of the country where people will want to move or own a second home.
When you end up with a speculative psychology, it tends to spill over into multiple asset classes, not just stock market valuations, where they are above the 90th or 95th percentile by most historical measures. Stocks are very, very expensive, historically speaking, but were seeing it in real estate, of course, weve seen it in cryptocurrencies, like bitcoin
shot up to $60,000 and now is struggling to stay above $30,000
Weve developed several tools over the years to try to tackle or track that psychology. Recently, we invented our Canary in the Coal Mine index. Its comprised of 20 of the most notable targets of speculation that have gone parabolic since the pandemic low. If you track the peaks in that speculation and see when that washes out, youre going to have a handle on when the trouble is going to start permeating into the rest of the market.
Gold: Where do you see the most speculative excess now?
Stack: Today, I think [speculative excess] is spilling over into all of the new IPOs, the SPACs (special purpose acquisition companies). Were raising money and we dont know what were going to do with it, but were going to buy something that makes money. And then weve got the new NFTs, non-fungible tokens, digital art I dont know if I can even describe adequately what it is other than the fact that its not really a physical asset. It is a digital image that you own, but everyone else has a right to see, use and everything. Ill tell you, its so extreme, its almost nonsensical. But its not unusual. From what we saw in the late 1990s, when companies could go public and had never made a penny, were starting to see a lot of that today in the meme stocks [so popular with the] new young traders.
You learn a couple of things as you go through these speculative excesses. Number one, bubbles can never be definitively guaranteed or identified until afterward. The second thing is that the bubble is invisible to those inside the bubble. In other words, dont go to someone investing in NFTs and try to tell them that theyre speculating in a bubble that could be almost worthless by the time it washes out, because youre going to get in an argument that you cant win except in the aftermath.
Gold: Youre talking about a possibility of both inflation and some big selloff in highly overvalued asset classes. Thats a tough market environment, so where do you think people should put their money and not put their money now?
Stack: We are in one of the most overvalued markets in history and one of the most speculative excess periods in history, so you dont have to be fully invested today. For our portfolio, we are short-term constructive on the market because were giving it the benefit of doubt, but were still carrying a 20% cash reserve just because it allows us to sleep at night. If youre going to invest in todays market, dont go out buying the SPACs or the stocks that have infinite PE ratios, because they have yet to make earnings. I would put higher allocations into those sectors that are going to benefit from, or at least be resilient to, increasing inflation. If inflation is sticky, if it stays higher, if we do see interest rates start to rise in terms of normalizing, then you want to be in sectors like the energy sector.
Now for purposes of disclosure, we do own these stocks in our clients accounts at Stack Financial Management. ConocoPhillips
is one of the worlds largest independent exploration and production companies, and oil prices
are over $70 a barrel. I wouldnt be surprised to see them continue to move higher through the year. The materials sector can benefit from rising commodity prices, and I think a company like Eastman Chemical
will do very well, and it pays a 2.4% dividend yield.
In the health-care sector, one of the stocks were holding is UnitedHealth Group
and carries a trailing P/E of only 23 times still pays a couple percent dividends, which is higher than the 10-year Treasury bond yield
Gold: Obviously there are plenty of ETFs in these sectors you said materials, energy any others that you like or that you would avoid?
Stack: If youre going to invest in ETFs, you can look at energy, materials or health care or, on the defensive side, consumer staples. Theyre out of favor right now, but theyre carrying some of the better valuations in this market. Value is what you want to be going for because weve seen a great divergence between growth and value, and growth has led the way out of the pandemic, but its also carrying some of the highest extreme valuations in the market. And when the Fed does decide to start taking the punchbowl away, thats where the pains can be felt the greatest. So, again, think safety first, and walk softly and carry a comfortable cash reserve.
Howard Gold is a MarketWatch columnist.