Third Year Curse, Bunds Break Out, Inflation Fears

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Third Year Curse, Bunds Break Out, Inflation Fears

The last few days have been choppy in US equity markets, so let’s talk about it with the help of some “Data” points.

#1: The curse of the third 10 percent year. This is going to sound simplistic at first, but there’s enough of the classic “Keynesian beauty contest” here that it should satisfy readers with a penchant for nth-derivative thinking.

As Jessica has mentioned in past reports, the S&P 500 only rarely cobbles together three years in a row of +10 percent total returns. Specifically:

  • 1930s/1940s: Only one +3-year string of +10 percent returns, during World War II (4 years, 1942 – 1945)
  • 1950s/1960s: One string of +3 years – around the Korean War (1949 – 1952, 4 years, just like WWII)
  • 1960s/1970s: One 3-year run, from 1963 – 1965
  • 1980s/1990s: only during the greatest bull market in history – 1995 to 1999, did we get a 3 year (plus, in this case) run of +10 percent returns, and every year was at least +20 percent
  • 2000 – present: only one 3-year +10 percent run, from 2012 – 2014.

This matters – a lot – just now because the S&P 500 is up 10.5 percent YTD and we’ve just had 2 back-to-back +10 percent years (2018: 31.2 percent, 2019: 18.0 percent). So, consider:

  • To buy or hold the S&P 500 right here you need to believe other investors believe there’s another 10 percent coming in the next 12-18 months. That’s the Keynesian beauty contest aspect to this analysis: determining what others think rather than simply relying on your perspective.
  • On the one hand, one can easily tell a macro story about how the current environment looks a lot like a wartime economy and comp 2019 – 2021 to World War II or Korea. National fiscal and monetary priorities center on beating back an existential threat.
  • On the other hand, it’s hard to believe markets will materially misprice corporate earnings power 3 years in a row. That’s why 3-peats of +10 percent returns are so rare: markets get to fair value (or above) pretty efficiently.

Takeaway: if you are tempted to reduce US equity exposure right here, right now, history is certainly on your side. We’re still of the mind that earnings expectations will continue to climb, and companies will be able to beat those elevated expectations because 1) American consumers’ ability and desire to spend is extremely high and 2) companies have underappreciated earnings leverage. As that story continues to develop, investors will grow to believe in another +10 percent year in 2022, and 2021 will see a continued rally. That’s what you have to believe to stay long the S&P 500 here; no other explanation really works.

#2: The German 10-year bund is showing signs of (inflationary) life. One of the few things that’s legitimately different about the last 2 days is that German 10-year yields are suddenly moving higher (less negative). This is a 5-year chart of bund yields courtesy of the CNBC website, and as you can see they’re rising sharply now and back to mid-2019 levels. Why? We believe it is increasing market confidence that Europe’s economy is finally starting to mend as vaccination rates across the continent improve.

Takeaway: if German bunds are starting to move, can long-dated Treasuries be far behind? They have been quiet for weeks now, but the move in bunds shows how quickly these moves can come in sovereign debt markets.

#3: Is inflation a self-fulfilling prophecy? We’ve seen a Google Trends chart in a number of places recently: the number of US searches for the word “inflation”, which is at an all-time high back to 2004. Macroeconomists would say that’s a good thing for near term consumption since it should make people want to buy before goods and services go up in price. But common sense says it might also increase savings and dampen consumption if Americans choose to conserve capital to pay for necessary future expenditures.

But, if Americans are really so concerned about inflation, then why are the number of Google searches for “cheap” and “low cost” not rising as well? They are, in fact, nearer their lows of the last 17 years, as these charts show:

Takeaway: there’s curiosity about inflation (which Americans clearly have), and then there’s actually acting on inflationary fears (which Americans clearly are not). For the moment, they seem to merely be “inflation curious”. All in all, that’s a positive for the near-term economic outlook. We’ll keep watching the “cheap/low cost” search volumes, though. Any uptick would mean inflation is actually starting to change consumer behaviors.


S&P annual returns by year: