At a recent seminar by Online Trading Academy (OTA) titled “Navigating the Everything Bubble”, Bachir Chaaya, gave a particularly enlightening talk. He began by posing three questions:
- Are we going to continue to see the inflation going forward, or is it transitory?
- Are we in an overvalued stock market?
- What should we do about these things?
He then launched into some history to give a deeper understanding of the situation regarding inflation. Going back to Germany in 1923, we see Germany’s Papiermark, their currency at the time, becoming entirely worthless. In Hungary, in 1946, just after World War II, the government began recklessly printing money which was coupled with a great deal of borrowing. This led to prices doubling as fast as every 15 hours in the local currency. In 1994, after the dissolution of the Soviet Union, the same thing happened in Yugoslavia. The 1990s saw Zimbabwe making some poor decisions which led to hyperinflation. By 2008, the government ran out of paper to print money with, and prices doubled every 24 hours. This is a story we saw repeated in 2009 North Korea, 2016 in Venezuela, and most recently in Lebanon in 2020.
Is the United States next?
There were three things in common with all of the above stories. They include:
- Excessive money printing
- Excessive borrowing
- Reduced production
After he discussed the history, Chaaya took a look at historical charts in order to assess where we are now. This included a chart of the overall M1 Money supply which shows a marked jump due to the stimulus payments. Next was unemployment, which while having dropped significantly since the depth of the pandemic, has still not achieved pre-pandemic levels. This could lead one to conclude that though there is a lot of money in the market, this increase may not be due to increased production.
The next chart Chaaya looked at was personal income. This has also seen a marked increase, but it too may not have been due to increased production. Once a salary goes up, it can be difficult to bring it down. Meanwhile commodities prices have risen 50% since the stimulus package began. Are these causal? That’s unclear, but commodities have risen a great deal.
Chaaya also took a look at the Breakeven Inflation Rate. This can be a great predictor of future inflation, and right now it’s predicting inflation may rise. It calculates the difference between the yield on 10-year non-protected treasuries and 10-year treasury inflated protected securities (TIPS). The higher that number, the more likely inflation is, and the number is going up, and right now the actual inflation rate is the highest it’s been since 2008.
There is another major variable at play here, which is the velocity of money. This shows that all of the money that has been pumped into the economy may not have been used for consumption of goods and services, but perhaps rather towards saving. This would mean that there is a lot of money in the economy that is not circulating.
What Evidence Is There of Higher Inflation Going Forward?
Chaaya summarized the main evidence pointing to the possibility of higher-than-normal inflation in the future because of the following:
- Higher wages without higher production
- Reduced economic output
- Higher Breakeven inflation rate
- Inflation at its highest value in 13 years
Is the Stock Market Overvalued?
To answer this question, Chaaya first looked at the Shiller Price Earnings (PE) Ratio. This is usually used to measure the ratio of the market caps of the stocks in the S&P 500 versus their average earnings for the past 10 years, adjusted for inflation. Right now, we are experiencing a Shiller PE Ratio that is the highest it has been in the twenty years. This is a possible indication that the stock market might be overvalued, but this does not necessarily indicate a change is on the horizon soon. While it is necessary to protect against the results of overvaluation, it’s also important to understand that it could continue.
The Price to Book Ratio, which compares the market value of a company to its book value (their assets minus their liabilities) , is the highest it has been in nineteen years. This indicates that things are becoming more expensive in an environment with reduced economic output, which could be a cause of problems in the future.
Finally, Chaaya looked at the market cap over Gross National Products (GNP) (aka the Buffet Indicator when used with the GDP). This is an indication of possible overvaluation in the stock market as well, indicating that things are becoming more expensive especially when there may be a lack of production to support it.
These indicators all lead to some major questions:
The Big Questions
Will the future be inflationary?
At least two of the three major factors for possible inflation are currently present: the government is injecting a lot of money into the economy, and printing a great deal of money, while users are engaging in a great deal of borrowing. On the brighter side, while there has been a drop in production, it is not stagnant. There is production and movement which the Real GDP figures reflect.
An argument for inflation is all those higher wages, which are hard to roll back. This means that we might see a continuation of rising consumer prices. On the other hand, you have the velocity of money, which has been hoarded. With the end of the pandemic, we may see a lot more consumer demand, which might cause that money to flow back into the economy.
Is hyper-inflation a probability?
Chaaya believes that hyper-inflation, or the massive devaluation of the United States dollar, while possible, is an unlikely event. This is in part because as long as it’s the most widely held reserve currency in the world, it will continue to act as an international medium for exchange in parallel to local currencies. Chaaya believes that, while possible, the international demand this creates makes the dollar an unlikely candidate for hyper-inflation.
Is deflation a probability?
Oftentimes, when deflation is talked about, the Lost Decade (1991-2001) in Japan in mentioned. Up until the late 80s, Japan experienced an unbelievable bull market, culminating in consumer goods becoming astronomically expensive. When things became too expensive, people saved more, and wouldn’t spend. This led to deflation.
There are several similarities between our current situation and Japan in the late 80s. One big similarity is how the Fed is responding, however, there is a major difference, in that the United States has much more of a consumer culture, as opposed to Japan’s saving culture. Another argument against future deflation is the rise of technological innovation which will allow for increased production to meet demand, especially that which might occur at the end of the pandemic. So overall, while possible, the likelihood of deflation is low in Chaaya’s opinion.
Is the market overvalued and due for a correction?
Many market valuations indicators are saying that the market might be overvalued, from the Shiller PE at an all-time high, to the Price-to-Book ratio. The current, high stock market valuation is largely being driven by share buybacks and higher than expected earnings. However, it is important to remember that these are made possible by the ability to borrow or refinance debt at cheaper than normal historical rates. Companies are “richer” because they are being given money, and while this is allowing them to be more productive, what happens when the cheap money spigot is turned off? Companies that are relying on debt to generate profits are likely to feel this in a big way. Even if the Feds raise market interest rates very gradually, the market is likely to react and could possibly overreact. That could be a catalyst for a major correction.
How should I position myself?
Right now, the Fed is stuck between a rock and a hard place. If it leaves the interest rates low, then inflation is likely to soar. But if they correct that by raising rates, it’s likely the market will overreact. This leaves them trying to strike a difficult balance and communicate without triggering an event.
In the face of such uncertainty, one way to position yourself is by identifying those companies with healthy balance sheets. This requires being able to read the financial statements of companies. It also means being able to build an adequately diverse portfolio—not just a 60/40 equities to bonds. A truly diverse portfolio is one of the best ways to shelter against the uncertainty of the future.
Those companies that are the most likely to weather inflationary pressure are those with zero to low debt levels. Companies that have the cash can survive troubles better than a company with high income and high debt. Other companies to look for are those that may benefit from the lift of the lockdown, like Starbucks. As investors, it’s important to assess a company’s intrinsic value with anticipated trends in the future.
A Diversified Portfolio
Because a diversified portfolio is so central to a sound strategy dealing with the uncertain future of the stock market, Chaaya took some time to delve deeper into this topic, laying out the criteria which a diversified portfolio needs to meet.
- Allowing for a continued growth in equities. We could be wrong about all of this, and the market could continue on a bull run. This would include a blend of small/mid/large companies, domestic and international, value and growth.
- Allowing for participation in the rise of the commodities market. This allows the investor to take advantage of the possibility of rising prices of commodities.
- Allowing for the possibility of a major correction if interest rates go up. This means investing in possible inflation-protected securities.
- Investing in companies that may benefit from the end of the lockdown and be better positioned for inflation due to pricing power.
Overall, it is critical to identify the companies and the funds to build a truly diverse portfolio, as well as to balance how to allocate funds to each of them. It is also important to have a clear approach as to what the long-term investment plan is.
Chaaya concluded his talk by sharing the extensive outline for his course, Prime Your Portfolio, designed to help you diversify and build a portfolio that could be better able to weather a storm.
The talk which Bachir Chaaya delivered for the Navigating the Everything Bubble Seminar is just one small example of the fine education offered by the Online Trading Academy.
About the Online Trading Academy (OTA)
Online Trading Academy (OTA) traces its roots back nearly 25 years to one of the largest trading floors in the United States. After managers and top traders began offering daily coaching sessions to help others, coaching eventually became the central focus, with the new OTA forming in 2001, devoted entirely to educating retail traders and investors. Their courses and many offerings are specially designed for traders of all levels, from the earliest novice to seasoned experts. OTA offers courses both in person, online, along with a a host of additional support and information.
Some of the latest news from OTA includes recent awards such as the Stevie Awards People’s Choice Award for Favorite New Product, awarded for CliK, OTA’s revolutionary new all-in-one education, analysis, and trading platform. Additionally, OTA won Bronze in the Stevie for Product Achievement in FinTech, also awarded for CliK.
One major new initiative which OTA has recently launched is Women in Trading & Investing (WITI). This exciting program is designed by women for women to help face the challenges that are unique to women in finance as well as to provide the support for participants to reach new heights in their confidence in trading and investing.