The State of the Markets

The COVID-19 situation is improving and a still damaged economy is recovering, but high market valuations and greedy sentiment suggest significant fragility exists. The time to prepare for the next sharp market selloff is before it begins, while conditions are still favorable.

As this article was being prepared, tragic events were unfolding in Texas after the state experienced subzero temperatures, ice storms, and mass power outages during and after the Valentine’s Day weekend. As seen nationally after the COVID-19 pandemic first hit the public consciousness in early 2020, the necessities for sustaining life quickly sold out across Texas stores. The current Texan experience, like many disasters before it, demonstrates the need for proper emergency planning prior to a crisis occurring. It is another sobering lesson for all leaders, policymakers, utilities providers, and communities.

Individual Americans can also take note that preparing ahead of time is essential for surviving natural and economic disasters, the goal being to limit one’s vulnerability to such events. Having the proper equipment and strategies in place prior to an emergency can transform a would-be disaster into a more minor disruption – or even an opportunity when it comes to investing. As shared in previous CWM market updates, given our historical track record, it’s wise to assume something in the world will catastrophically break at least once per decade and plan for that possibility.

Looking at economic and market data today, the signs of potential market fragility are widespread, though there are pockets of good news as well. Proper analysis takes the good with the bad and then formulates a cumulative outlook. In the current environment, much is still dependent on outcomes related to COVID-19, the balance of power in the U.S. Congress, recovering economic activity and of course, the various factor groups that the CWM team relies on to help make decisions around client investment portfolio risk exposures.

COVID-19: The Key Data Points

The COVID-19 pandemic and the ongoing vaccination efforts remain the area of primary focus not just for stock market watchers, but also for the world at large. When considering the impact on investment markets and the economy, two COVID-19 related data points stand out in particular: the number of Americans currently hospitalized and the percentage of the American population that has received a vaccine (at least one dose). Reducing the number of hospitalized individuals while simultaneously increasing the number of vaccinated individuals will be the primary factors in determining when life can begin to resume some semblance of the normal that existed prior to February 2020. Fortunately, there is good news to report on this topic.

Given that the primary goals of the economic shutdowns taking place worldwide are to prevent medical systems from becoming overwhelmed, and causing excess mortalities, COVID-19 related hospitalization data is important to consider. If hospitalizations fall and remain low, there will be justification for removing the restrictions that have damaged wide swaths of the economy, particularly in the services sector. While still high relative to earlier in the COVID-19 experience, hospitalizations related to the disease have been falling sharply since the beginning of the year.

Source: US Currently Hospitalized With COVID-19. (February 16, 2020). The COVID Tracking Project.

While it is probably too soon for the vaccine to have a notable influence on current hospitalization data, having a population widely protected from the virus should help decrease future cases of infection, and more specifically, curtail serious symptoms that require hospitalization. The map below details the reported levels of each state’s population that has received at least one of the two vaccine doses.

Source: See How the Vaccine Rollout Is Going in Your State (February 16, 2021). The Morning. The New York Times.

The goal of the vaccination program is to immunize as many people as possible to achieve a level of “herd immunity,” in which a large majority of a population being inoculated inhibits the spread of the infection. Dr. Anthony Fauci, the director of the National Institute of Allergy and Infectious Diseases, has gone on record stating that a 70% – 90% vaccination rate may be enough to establish herd immunity to COVID-19.1 Current vaccination forecasts are estimating that:

    • One-quarter of Americans will have received their first shot by April 1st
    • Half by June 1st
    • Three-quarters by mid-autumn2

The above schedule means Dr. Fauci’s estimate of herd immunity could be reached by mid-autumn, but there are of course many things that could change between now and then that could affect the current expectations for good or ill.

Low levels of hospitalizations and a high rate of inoculation would suggest that the U.S. is successfully preventing the worst COVID-19 related outcomes from occurring, which should allow for removal of restrictions, reopening of the economy, and a return to pre-2020-like normalcy. Continued improvement of these two COVID-19 related data points should be good for the future economy, which should, in turn, be good for company bottom lines and stock prices.

A Brief Look at Politics: Rule by the Center

A previous CWM blog post (What a Change in Legislative Control Means for You and Your Portfolio) covered some potential outcomes related to the recent election results, so this section will be brief as a result.

What is important to know about the current balance of control in both the House and Senate is that Democrats have one of the slimmest margins of control in U.S. history in both chambers of Congress. This means that only a few votes need to change sides to scuttle any piece of proposed legislation. Recent years have seen government swing towards one end of the political spectrum or the other, dependent on the party of the majority. As it stands today, centrists probably have the greatest influence they have had in decades, which will likely limit the possible legislation that can get passed and make more politically radical legislation unlikely. Investment markets tend to value certainty and dislike surprise, so this current governmental arrangement could be positive for investors.

Source: Cembalest, M. (January 6, 2021). Eye on the Market. J.P. Morgan.

Source: Cembalest, M. (January 6, 2021). Eye on the Market. J.P. Morgan.

Economic News: Recovering, But Not Recovered

Now for a bit of bad news. While the economy has been recovering, it has not fully recovered, with U.S. gross domestic product still well below the previous trend level growth expectations

Source: Kelly, D et. al. (February 16, 2021). Guide to the Markets. J.P. Morgan Asset Management.

Unfortunately, there are growing signs that the recovery is petering out a bit in the high-frequency data that is available on a more continuous basis. This data has not fully recovered (exception: mortgage applications) and it is plain to see that most measures have flatlined or even turned negative once again after showing strong recovery last year. Already expensive market valuations may become tenuous without a firm future positive economic expectation to justify them.

Source: Kelly, D. et. al. (February 16, 2021). Guide to the Markets. J.P. Morgan Asset Management.

A stalling economic recovery at this point could be devastating for the 20+ million Americans still requiring economic support. It is worth noting that most claimants are on the pandemic assistance plans (Pandemic Unemployment Assistance and Pandemic Emergency Unemployment Compensation), which means these are long-term unemployed persons that have already exhausted their traditional unemployment benefits. If it were not for the continued support programs, these individuals would be without income.

Source: Rabouin, D. (February 12, 2021). Axios Markets. Axios.

It is also unfortunately true that the ones most likely to suffer a job loss have been those who previously made less than $27,000 per year. This is likely related to the fact that a great deal of COVID-19 disruption occurred in the low-wage service industry, affecting companies like restaurants, entertainment venues, barbers, etc.

Source: War Room: Fed-Treasury Merger. (January 28, 2021). Hidden Levers.

To end this section on a positive note, there is ample evidence that the American entrepreneurial spirit lives on. Despite the many challenges that 2020 provided, there were still people filing new business applications and attempting to live out their capitalistic dreams. As long as Americans are continuing to form businesses to solve society’s problems and meet its needs, the U.S. economy should be fine over the long run. That does not mean stock markets can’t get ahead of themselves from time to time.

Source: Koeze, E. (December 18, 2020). How the Economy is Actually Doing, in 9 Charts. The New York Times.

The CWM Data-Based Outlook: Markets Are Currently Fragile Based on History

The problem with good news, at least from a market perspective, is that it eventually gets priced in. Then, sometimes optimistic expectations, and stock market values, can get a little carried away since markets are driven by humans and their behavioral flaws, with greed being one of the said behaviors.

There are legitimate reasons to be optimistic, such as positive price momentum, historically low interest rates, massive government support, and the various economic positives discussed earlier. It is also possible that markets, as a forward-looking device, have overpriced those positives and have become vulnerable to negative shocks. The economy remains relatively weak and there are still many unknowns about how the U.S. and world emerge from the COVID-19 debacle. Despite that, market valuations are at extreme outlier highs and measures of investor greed are vigorously waving red warning flags. Regular readers of the CWM blog and attendees of CWM’s Thirdly Events will recognize the below factor wheel that summarizes the categories of data believed relevant for portfolio decision-making. To summarize, high levels of market valuation and investor greed are being supported by long-term positive market momentum and all-time low interest rates despite a still recovering and perhaps sputtering economy. The positive factors may be enough to hold markets together for some time yet, but the negative categories are providing strong warning signals about potential future market outcomes.

Source: CWM Factor Groups. (February 16, 2021). CWM Data Analytics.

The biggest red flag of the factor groups is valuation. Currently, U.S. market cap-to-GDP is well over 196%, which is over twice the mean (average) level of 84.83%. Throughout the time period shown in the below graphic, it is more normal for the combined market capitalization to be less than GDP, not more than double. The current reading is ~3.5 standard deviations from the mean and readers with a statistics background know that figure indicates that market valuations are at extreme outlier levels, which are rarely expected to be seen and are likely unsustainable.

Also on display in the below chart is market momentum, which is approaching an almost vertical slope of the line at the right side of the chart. Momentum is positive for now, but the rate of change is unusual based on history and likely unsustainable.

Source: The Federal Reserve Bank of St. Louis. (February 15, 2021). CWM Data Analytics.

Another positive or supporting factor is all-time low interest rates thanks to the Federal Reserve (Fed)’s easy money policies that are near record lows. Low interest rates can justify higher stock price multiples but can be a double-edged sword if interest rates begin rising too quickly as they have done in longer-dated debt instruments over the last few months.

Source: Effective Federal Funds Rate (February 15, 2021). The Federal Reserve Bank of St. Louis.

The economic data echoes what was discussed earlier in this article, where current readings are still below previous level, but recovery is occurring. The Fed’s Weekly Economic Index is a helpful gauge of economic activity that displays readings weaker than those of 2019, but much stronger than the low in 2020. For now, it can be said the economics are poor but recovering. The direction of the data points’ movement is more important than the nominal level of the reading.

Source: Sonders, L. et. al. (December 8, 2020). 2021 Schwab Market Outlook. Charles Schwab.

A favorite CWM measure of greed/fear is the CBOE VIX index that measures investor expectations of future volatility. High readings suggest investors believe high volatility is likely, while low readings represent low volatility expected in the future. At 21.46, the measure is currently just above its long-term mean of 19.49, suggesting a degree of market complacency considering the nosebleed valuations shown above. Valuations suggest a major ice storm is probable and based on the VIX, investors don’t appear to be concerned enough about it to buy a new coat, stock up on food, and chop a little extra firewood.

Source: CWM Data Analytics. Yahoo! Finance. (February 16, 2021).

Citibank's panic/euphoria index has greed on full display, recently having to adjust its chart's vertical Y-axis to accommodate a never-before-seen level of euphoria. A wise investor is fearful when others are greedy...

Source: Authers, J. (January 24, 2021). The Stocks Bubble-O-Meter Is Flashing Bright Red. Bloomberg.

Greed (or perhaps just extravagance) can also be seen in the collectibles market where signs of froth are evident in some fun examples. Speculative investors have run amok in cryptocurrencies and other high-risk, but still more traditional style, investment products. They have nothing on collectible trading and playing cards over the last year where irrational purchasing behavior is clearly on display.

• Two Michael Jordan rookie cards, in mint condition, just sold for $738,000 each. In March last year, the same card was going for less than $50,000.
• Last month, an ultra-rare Alpha Black Lotus Magic: The Gathering card sold for $511,000, shattering the old record of $166,000 in 2019.3

Source: Cracknell, R. (n.d.) Pair of 1986-87 Fleer Michael Jordan Rookie Cards Sell for Record-Setting $738,000 Each. Beckett. Hall, C (January 27, 2020). Magic: The Gathering Black Lotus Card Sells for $511,100 at Auction. Polygon.

Related to the above discussion on greed, but not truly part of the CWM PTS® (Performance Targeting System) factor model, is the trading behavior of corporate insiders. While the overall market is historically expensive and frothily euphoric, the people with the greatest access to information are selling their own company stock at the fastest rate in the last 10 years—so fast, the low net buying percentage level is a statistical outlier. A wise investor takes note of the behaviors of those with the most information.

Source: Hulbert, M. (February 8, 2021). Insider Selling is Alarmingly High and Small-Cap Stocks are in the Crosshairs. MarketWatch.

At this time, your CWM team remains concerned primarily about all-time high valuations and levels of investor greed/euphoria, especially considering the possibility that markets may, at least in part, be built on liquidity driving policy decisions of government or central bank officials that could be changed in an instant. As most CWM clients know, a strong investment philosophy of the team is, “Expensive things are dangerous,” and it is difficult to find a more expensive market environment than the one we are living through today. Expensive markets do not always crash, but they frequently are followed by a period of very low long-term returns. For now, a smart course of action is probably taking limited risks that provide some possibility of upside participation in case markets continue to rise, but remain defensively postured overall while awaiting market environments with better future return prospects. When a storm seems highly probable, it is best to prepare for it before it arrives.

Please pass this article on to anyone you know who may be interested in or might benefit from the information. We are always looking for more great clients like yourself and would welcome any opportunity to assist them.

If you have questions or comments about the above subjects or other investment topics, I would love to have a conversation! Feel free to email me or, if you are interested in more regular financial tidbits, follow me on Twitter.

P.S. Most bad weather, and bad markets, can be survived and even enjoyed as long as you are properly prepared— as my kids demonstrate when they go for rainy puddle-stomping walks in their boots and muddy buddies.


1Allen, J. (December 24, 2020). Fauci Says Herd Immunity Could Require Nearly 90% to Get Coronavirus Vaccine. Reuters.
2Leonhard, D. (January 13, 2021). The State of the Pandemic. The New York Times.
3Five Things to Start Your Day. (February 8, 2021). Bloomberg.

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