“Equity markets that seem conditioned to getting central bank largesse at the first sign of major trouble now face a key test, as the US Federal Reserve’s balance sheet continues to shrink, albeit very slowly,” says Russ Mould, AJ Bell Investment Director. “Data from the American central bank shows a fourth consecutive reduction in total assets and, at $88 billion, it is the biggest drop since chair Jay Powell sanctioned a massive expansion of Quantitative Easing back in March.
Source: FRED – St. Louis Federal Reserve database, Refinitiv data
“The Fed has provided some $3 trillion in extra liquidity since March and on the face of it American equities have feasted on that lolly: the S&P 500 index bottomed on the very day that Mr Powell launched the US central bank’s latest monetary bazooka, partly to ensure markets remained liquid and continued to function and partly to support the wider US economy.
“Interest rate cuts and efforts to manipulate bond yields lower left investors looking for a new home for their cash in their quest for a return on that money. Whether goosing asset prices, as some have accused the Fed of doing, is the best way to support the economy is open to debate, as it benefits the asset-owning wealthy much more than those who are less well-off and in need of the greatest assistance. Perhaps the Fed is now becoming nervous amid fresh talk of bubbles developing across a range of asset classes, but especially equities and tech and biotech stocks in particular.
“Their dominant performance makes sense in the context of a low-growth, low-inflation, low interest-rate world. Low growth means any firm that offers premium rates of increase in sales and will be very highly prized, while lower interest rates lead to lower discount rates in the discounted cash flow (DCF) models that are used to price up long-term cash flows and by implication boost equity valuations.
“If investors think this situation, already the dominant investment theme for the past decade, is set to continue, then it is easy to make the case further tech and biotech outperformance, despite grumblings about valuations and bubbles from those investors who remember the way in which technology, media and technology stocks frothed up and then boiled over in 1998-2000, with ultimately damaging results to investors’ portfolios: the NASDAQ Composite peaked in March 2000 at 5,084 and then took 15 years to get back there.
Source: Refinitiv data
“The NASDAQ stands at a fresh all-time high and is so far easily shrugging off the Fed’s marginal tamping down of its QE scheme. The S&P500 is coping well enough, too, although it may not be a coincidence that the S&P seems to be finding the going a bit tougher now the Fed is playing a little bit less fast and loose. Equally, the fresh viral outbreaks across America’s sunshine belt could be a valid explanation for the S&P’s loss of momentum after its huge gallop higher.
“A greater danger still to the NASDAQ in particular, therefore, could be the (entirely unexpected) demise of the low-growth, low-rate, low-inflation environment.
“If there is a real cyclical recovery then investors would not need to pay very high multiples to access secular growth when they could buy downtrodden value stocks that offered cyclical growth on much lower multiples.
“While this may seem unlikely right now, it will may need something similarly unexpected to knock tech stocks off their stride and if something strange does happen the effects could be devastating, if the experiences of the Nifty Fifty in the early 1970s are any guide. Investors piled into names such as Polaroid, Eastman Kodak, Xerox, Upjohn, Burroughs, DEC and IBM in the view that they would provide greater upside and greater safety only to be massacred during the 1973-74 bear market, as the valuation multiples up to which buyers had bid these names meant they actually offered little or no protection at all.
“Although valuations – in some cases – do not feel as extreme as they did in the early 1970s, they are in others as the momentum crowd jumps in. And it may not be an entirely healthy sign that six stocks – Facebook, Alphabet, Amazon, Apple, Netflix and Microsoft (FAAANM) – have gained $2.2 trillion in value over the past 12 months, while the S&P 500 in total has gained $1.2 trillion. That doesn’t say much for the other 494 names and the S&P 500’s market cap now is no higher than it was in January 2018, if you exclude the FAAANM sextet.”
Source: Refinitiv data
