Don’t Speculate on Speculation

The stock market rally so far this year seems based largely on speculation rather than fundamentals. Investors appear hopeful the Federal Reserve will soon return to a policy of cheap and abundant liquidity while ignoring the Fed’s repeated warnings to the contrary.

Speculation and bubbles require significant liquidity. Economic fundamentals do not point to the Fed soon changing course and easing credit conditions or lowering interest rates and have more recently argued the exact opposite: the Fed could stay tighter for longer than investors currently expect.

Accordingly, we continue to be defensively positioned within our portfolios, rather than loading up on those assets most likely to fizzle out.

Liquidity is a cornerstone of bubbles

We have repeatedly highlighted our five characteristics of a financial bubble. The cryptocurrency and tech/innovation/disruption outperformance during 2020-21 fit all five of these characteristics.

The recent bubble in technology/innovation/disruption/cryptocurrencies was undoubtedly fueled at least in part by the Fed’s immense liquidity injection into the economy in response to the pandemic (See Chart 1). M2 growth peaked at 27%, which was the highest in modern history and put US monetary growth on par with Peru’s. Fiscal stimulus provided additional liquidity via emergency payments.

Because businesses were slow to utilize the capital and consumers were not using services, the extreme amounts of liquidity basically had nowhere to go except into savings. That huge pool of excess savings quickly spurred a financial bubble.