Is the market too rich and too thin?

Good morning. Fed day! Good luck everyone! Email us with predictions before the release lands this afternoon! robert.armstrong@ft.com and ethan.wu@ft.com.  

Into the narrows

Like a concerned parent clucking over a wan teenager, investors are worried that the market looks thin. Breadth — an umbrella term for various measures of the proportion of stocks in an index that are performing well — has collapsed. Does this mean those few stocks still hitting highs are on borrowed time?

Here’s Jared Dillian at Mauldin Economics writing in Bloomberg:

There have been episodes of declining breadth in the past, and those usually presage large corrections or bear markets. The Nifty 50 episode in the 1960s is one example. But even in the dotcom bubble, breadth declined steadily until March of 2000, at which point there was only one stock standing: Cisco Systems. When Cisco broke on an earnings report, that was it for the dotcom bubble.

Does a narrowing market really presage a downturn? As Dillian notes, it sometimes has, but there have been false dusks, too. The chart below shows the past two decades of monthly S&P 500 downturns against market breadth:

Other than the fact recessions are bad for stocks, we don’t see an obvious relationship in this chart. In June 2010, bad breadth accompanied a market thrashing, but even worse breadth sounded a false alarm in September 2014. A period of persistent market thinness around 2015 coincided with stocks trading sideways. A simple regression analysis finds that weaker breadth didn’t correspond with future market slides.

Even seemingly straightforward examples such as the dotcom bubble contain subtleties, as Capital Economics’ John Higgins pointed out in a recent note:

[T]he S&P 500 has sometimes narrowed for a long period without falling sharply. It did so during most of the second half of the 1990s, as the dotcom bubble inflated. That bubble only burst around the turn of the century. And it did so for most of the second half of the last decade — when the index generally soared — before the onset of the pandemic.

We sympathise with the jitters, though. Valuations are stretched, the S&P 500’s real earnings yield is at a record low, and macro conditions look increasingly inhospitable. The top-heaviness of US equities’ performance inspires fear that investor sentiment is turning sour. This amusing pie chart from Bank of America’s strategy team drives the point home:

Can a rich, thin market be sustained by a handful of super-stocks? Perhaps. We do seem to live in an increasingly tech-driven economy, where network effects and increasing returns to scale mean a few companies make most of the profits, and everyone else fights for scraps. In such a world, one would own a stock index not to capture broad returns, but instead knowing that returns would be very unevenly distributed, in ways impossible to predict in advance.

Crazy lumber inflation is back

Someone pointed out to me this summer that inflation is always idiosyncratic. For every item or commodity or service that is rising in price, there is a particular and usually surprising story about why people want more of it than usual or the supply is abnormally constrained, or both. It is therefore tempting to explain away every particular instance of inflation, and so deny, a little bit at a time, the general economy-wide inflationary trend. This would be a mistake.

Such was the case with wild timber prices in the spring of this year. Yes, they were historically unprecedented, but look closely at the market and you find a one-off burst in DIY project spending by cooped-up homeowners meeting very cold weather in the lumber-producing areas of the US south-east, which shut sawmills. Things duly got back to nearly normal by summer. Sometimes inflation just goes away, and that is very reassuring.

Sometimes, however, inflation goes away and then comes back. That is not reassuring. And all of a sudden, lumber is back at $1,000 per thousand board feet (data from Refinitiv):    

Paul Jannke, lumber principal at the consultancy Forest Economic Advisors and our go-to lumber guy, said demand has been strong since Covid hit, but the real swing factor has been supply. In sum:

• There is always a seasonal slowdown in buying by lumber wholesalers in October and November. Delivery from mills, and then delivery to retailers, takes about three months, and retail lumber demand is weak in the dead of winter. It is normal for buying to pick up in December, but

• The import duty on Canadian is very likely doubling soon, to 18 per cent, and

• Many wholesalers held off buying until recently in anticipation of a large amount of sawmill capacity that was set to come on in the south, but labour shortages at these mills have limited production, and

• Very wet weather has made it hard to pull trees out of southern forests (heavy equipment tears up the moist forest floor). Finally,

• In British Columbia, the highest-producing region in Canada, rain was so heavy this year that much of the harvest (already much reduced by the mountain pine beetle) was prevented from reaching the market.

“Typically lumber prices are $350 to $400. The move to $600 is lack of supply coming from the south — about $100 of that is labour shortage and $100 is weather. The jump past $700 is down to the lack of supply from British Columbia — which dragged the whole market higher,” Jannke says.

For those worried that inflation is going to persist, the point that sticks out there is the one about mill labour. Jannke says that mill jobs tend to be in rural locations and not very well paid — and yet in modern mills the jobs require tech savviness, too. So potential workers can often find better paid work that is less remote, a long-term problem for the industry.

Are lumber prices one of those idiosyncratic stories that, all the same, reflects wider inflationary pressures? Right now, labour issues have pushed prices up by something like 25 per cent, on Jannke’s account. That’s significant, even if the other, larger contributors to the supply shortages subside soon.

One good read

Over at Alphaville, Jamie Powell sees an early indication that companies that “won” Covid might have pulled demand forward from the future — and could see sales fall sharply post-pandemic. We will keep a close eye on revenue estimates and guidance in the months to come.