Lockhart Capital 2021 Outlook

In some ways 2020 was simply a continuation, and huge exacerbation, of existing trends and distortions.  Historically low (and for longer) interest rates, central banks de facto funding budget deficits, and previously winning sectors and stocks now doing even better.  The pandemic was certainly not bad news, business-wise, for Amazon, while for bricks and mortar retail just when they thought things could not get any worse…they absolutely did.  Pub landlords must feel like they have been cursed.

Fig 1 (Source: InvesTech Research)

We acknowledged the underlying pro-cyclical tone of the market in the last few months of the year, heeding the warning not to be too bearish, despite rich valuations.  This could be assessed by a variety of measures including liquidity and investor confidence.  One of the indicators that we highlighted was the performance of IPOs.  However, this now describes speculation (see Fig. 1.), and would still do so even if it were profitable businesses coming to market (not currently the case).

This mania can also be seen in the % of US stocks that are suffering from “severe overvaluation” (red line on Fig. 2.) versus those that are “severely cheap” (green line).  Quite a dramatic move at year end, even on a 40 year chart:

Fig 2 (Source: Sundial Capital Research)

Therefore, it should be no surprise to hear that the bulk of the performance from the equity markets in 2020 was not from economic return but from valuation expansion, which is to say that investors were willing to pay much more for the same single dollar of earnings.  The yellow shading in the following chart (Fig. 3.) illustrates such periods, while the blue area denotes earnings growth, which, to the contrary, was negative in 2020.

Fig 3 (Source: Minack Advisors)

Consequently, we have this bubbly environment (Fig. 4.), whereby the US equity market is trading at highs in terms of price and valuation, but also relative to the size of the economy (GDP), sometimes known as “the Buffet indicator” (given that it was first popularised by Warren Buffet).

Fig 4 (Source: Haver Analytics, Rosenberg Research)

Another way to consider the level of speculative behaviour is to deconstruct the market into three slices (Fig. 5.); the tangible book value of stocks (pink area), the forward earnings (blue area), and what is left over (orange).  It is that last element that one might define as intangible “hope value”, and seems somewhat excessive right now.

Fig 5 (Source: Bianco Research)

This is what happens when central banks print money that stays within financial markets, and while investors have boundless confidence that policy makers have their back.

As any saver knows, the “risk free rate” these days is tiny, and, in post inflation terms, negative.  This has forced investors up the risk scale, where they were then picked up and carried along further by the wave of liquidity from monetary and fiscal policy, causing a self-reinforcing loop of price momentum and market confidence.

Benjamin Graham once said that “In a roaring bull market, knowledge is superfluous, and experience is a handicap.”  However, the direction of travel does not have to be entirely wrong, as long as fiat (paper) money is getting debased, which it is.   However, investments without positive earnings or economic yield, will be in trouble the longer they remain floating on hope and liquidity.   This is because this is the only economic environment in which they can survive in this way, and economic environments and cycles change.

So, one might have been forgiven for running a far lower exposure to equity markets.  However, valuation is not a market timing tool, rather it is a measure of margin of safety and risk versus reward.  Hence, while reduced exposure to risk assets is sensible and appropriate, we do like to invest in trends, as per our process, and which we think will continue to be a key part of the market landscape for years to come.

We also suspect that a small part of markets is sniffing out the inflationary results of monetary and fiscal policy, quite rightly, and that, over time, assets are more attractive than cash.  Equities will not be the worst performer (though will be volatile) in an inflationary environment, and some exposure is indeed required as one defends the purchasing power of a portfolio.

Our stated expectation was that, as ever, excess money creation would feed into financial markets, but also non exchange traded areas too, including what we loosely defined as “collectibles”.  Collectibles is not really an asset class, but can be thought of as entities of limited supply and of individuals’ personal preference, i.e. can also be enjoyed, in the broadest sense.  There is usually little economic value or yield to such items, and they trade infrequently and with the price pushed around by the whims of fashion.

In any event, this might include Art, Wine (a case of Château L’Eglise-Clinet 2010 Bordeaux rose 37% in 2020), Vintage Cars (rare Ferraris were up 14%), Stamps, or Bitcoin and usually includes annoyingly-high associated costs of insurance, storage, and dealing.  Consider our not-entirely-throwaway line, “even baseball cards”.   We mention this as, a Wayne Gretsky rookie card (ice hockey) sold for $1.3m recently, and a signed Mike Trout rookie card (baseball) for near $4m, having been bought for $400,000 just two years previously.  Our expectation was, and is, that this area would benefit from money printing, though eventually give way to outperformance from more productive assets.

Inflation is often kryptonite to investment portfolios, but potentially never more so than today, given valuation multiples.  Like in Pascal’s Wager, even if you perceive the chance of this outcome to be small (we don’t), the resulting impact is so large that it still must be accounted for in portfolio construction and risk control, even dominant.  The rational Pascal must live as though God exists, while the rational investor must construct his portfolio as though inflation will increase, and interest rates rise.

Inflation can destroy the real purchasing power of money, but also suggests a material increase in interest rates, which would finally shine the light of reason on the valuation of markets and asset classes.   This will surely result in the rug being pulled from underneath them if you will excuse the mixing of metaphors.  This is the greatest foreseeable risk for those seeking to preserve and grow wealth.

It is our contention, and we are not alone, that economies and markets have never been more interest rate sensitive, given debt levels and yet anaemic trend economic growth.  Clearly policy makers will aim to avoid the most negative of outcomes, but there are scenarios in which they would be powerless.  For example, the US Treasury market is simply too big, and the funding (and re-funding) requirements of the government too large, for the Federal Reserve to be able to withstand the withdrawal of 3rd parties, private investors, institutions, and foreign entities.  This would be the scenario whereby the Fed “loses control of the bond markets”.  This is entirely possible, and the only thing stopping it is confidence. Is the slowly boiling frog going to jump out of the pot, and if so, when? Markets may not force interest rates up if there is some real economic growth, but they surely will if there is inflation.

Consider that an inflationary recession can happen simply because people lose faith in fiat (paper) money, and whose debasement appears to be a policy goal from which we will not waver.  When confidence goes, it goes abruptly.   You cannot be a little bit pregnant.  This will likely occur, sooner or later, as politicians will borrow more and for longer against that “faith”, perhaps in the name of equality and justice, which not unreasonably might have public support.  Faith is the last “asset” left for policy makers to siphon off and trade in to the pawn shop.

We say “last”, as the developed world no longer has a “demographic dividend” as a tailwind, suffers from low levels of productivity and economic growth, and has reams of debt to service and unfunded liabilities for which to provide.  Interest rates are already at all-time lows and aggregate taxes near highs (versus the size of the economy).  Somehow a course needs to be plotted away from the Covid-induced closedown of economies, and the population supported.

There is now even less than zero appetite for “austerity”, and furthermore it is difficult to see how the current exceptional support programmes can be scaled-back either much in size or time.  The expectation remains that governments will continue to spend.  They have saved bankers and institutions in the past, so there is no excuse for failing to support those who have lost livelihoods and opportunity over the last year, through no fault of their own.  This means significant ongoing fiscal support, which for the last year has been financed by central banks.   Surely that can only continue for a limited period of time, at least until if and when the bond markets take the “printing press” away.

The approach will be to try and engineer negative real interest rates, i.e. inflation above interest rates, for as long as possible.  This was how the post-World War two debt burden was worked off, although it must be said that the context is very different this time.  Our expectation remains that this will debase the currency/ies.  For as long as it works it could allow bond prices to remain quite stable in nominal terms, but quietly bleeding to death in real terms.  Other assets might be much more volatile, and of which portfolio managers will need to take account.  It also suggests more and longer trends, which has been part of our investment thesis since our launch, and further need to find more diversifying investments and strategies, given that bonds can no longer be relied upon to do the job.

The question then is how long this phase will last, and, given that it will rely on confidence it is impossible to measure or predict.  However, eventually these policies will end either by choice or when policy makers’ hands are forced.  As that eventuality gets priced into markets, trends will abruptly reverse, and investors will likely decide to pay a lot less for the same dollar of earnings, and those earnings will themselves be under pressure.  Well-constructed portfolios will have plenty of other strategies (perhaps volatility, and even digital assets, for e.g.) at hand to take the strain, and to rotate towards risk assets at then more favourable prevailing valuations.

We are sceptical of the assumption that 2021 will be a great year of recovery, although yes there will be an obvious improvement in year-on-year numbers, especially in the second quarter.  If there is indeed a dynamic recovery it is more likely to be what the Austrian economist Ludwig von Mises described as a “crack-up boom”.  This is when investors fear a currency of increasing supply, and rapidly exchange it for real goods, while they can and while it still has some value.  This occurred in the 1920s in Germany, for example.  Optically speaking there is then a boom-let in economic activity, and an increased velocity of money, but it is caused by fear and turns out to be vicious rather than virtuous.

One of the reasons that we fear for the economy, and expect more social tensions, is that inequality continues to go the wrong way, and has been exacerbated by Covid. The upper middle classes work from home offices and take deliveries from those in the working class …at least the ones still employed and able to work.  Restrictions on life and livelihoods were imposed by those who would not personally feel the loss of a business, job, or ability to put food on the table or pay a mortgage.  The unintended consequences, even just in the realm of mental health, are vast, and the “cost” of the pandemic response will prove astronomical and be with us for years and probably decades.  The wealth and worth of developed nations, already under pressure, are taking a significant one-off hit, but which also further impacts trend growth and the compounding effect thereof.

So, inequality has risen further, not fallen. The only comparable loser has been government finances, which is ironic, as they were in any case in terrible shape and with poor prospects at the start of 2020.  With such low rates of productivity and trend growth, and negative demographic profiles, there is simply no way that the developed world can grow its way out of its debts and liabilities, especially with interest rates already at rock bottom.  The parallel of 1945 to the 1980s, their only hope, is simply not an appropriate comparison in our view.  So, the answer is default or inflation (de facto default), with the latter being the preferred option by most policymakers.

 The following chart (Fig. 6.) shows how the pandemic-induced jobs crisis is hitting those who already have the more tenuous situations, the most:

Fig 6 (Source:

The next chart (Fig. 7.), from the Washington Post, describes how even an average household can no longer meet its annual expenses.   This is due to relatively stagnant wages, but also because the price of what you want may be in reach but the price of everything you need has gone up.

Fig 7 (Source: The-Cost-of-Thriving Index, The Washington Post)

Perhaps the most disturbing data is around achievement depending on educational outcomes.  In the 1950s and 1960s you did not need a bachelor’s degree to generate a middle-class lifestyle, and this aided social cohesion.  This is no longer the case, and the following (Fig. 8.) shows the alarming decline in mental wellbeing (US).  It is the inability to live with dignity that is a key factor behind the rise of popularism, and which is not going away until this is addressed.

Fig 8 (Source: 1972-2016. Twenge, J.M.,& Cooper, A.B. (2020)


Spendthrift policymakers are, essentially, rapidly filling in a hole as fast as they can, but with dirt they are digging up out of another hole.  There may be little else that they can do, and it fits within the modern milieu whereby we have been addressing debt-induced crises with simply more debt.  We would agree with Churchill that trying to increase prosperity through tax rises is often akin to “a man standing in a bucket and trying to lift himself up”.  Nevertheless, in the short term it may somewhat appease bond markets to at least appear to be trying to balance the books, on some small scale.

To be clear, Governments have only been able to support their economies (and voters) because Central Banks, which are notionally independent, are prepared to buy up their largesse in the bond markets. However, this cannot go on forever and without consequence.  Investors are already starting to require a higher yield on US Treasuries, given President-elect Joe Biden’s spending promises.  We do feel that the Democrat domination of Washington DC is a negative for capital and long-term real growth, although is likely stimulatory for 2021.

Fig 8 (Source: Minack Advisors)

It is the US that suffers the most egregious inequality of income and wealth, and where an increasingly polarised electorate has been wound up by a childish media that sees itself as entertainment and opinion, rather than purveyors of sober reporting.  There seems little willingness to debate and negotiate these days, or an understanding that we always have more that unites us than divides us, although it is said that you get the politicians that you deserve.

Both sides are culpable, and encourage and enable their more extreme supporters.  It would be a wonderful New Year’s resolution if everyone agreed to end the role of ludicrous hashtags, from #notmypresident to #fightthesteal.  Nothing good has come from them, and if we always have 40% of the population convinced that their President is somehow illegitimate, that must be a suboptimal outcome, and not just socio-politically.

There is probably a positive in the US no longer being de facto run by Ivanka Trump and Jared Kushner, if that indeed was the case.  Whether a Biden administration can address inequality and those “left behind” any better, remains to be seen, but he will likely print more money in the endeavour, or at least that is the way to bet.  Herbert Hoover once said “We have gold because we cannot trust governments”, which we suppose is a fair summation.

So, looking forward, investors will need patience, humility, and a little (/lot of) good luck.  There are a lot of extremes around at the moment, and a status quo that feels more fluid than normal.  New data means yesterday’s strong view can lie at the bottom of today’s trash can. Investors will need to be entirely objective and adaptable.   It helps to be unremorseful about the demise of that previous view, which yesterday may have been entirely intellectually coherent, given the information available at the time.

We attempt to be as dispassionate as this would suggest, and build this into our processes to guide against emotional response and the tyranny of always living in the present moment!  It is important to remember that we will always be closer to knowing nothing than knowing everything, and to invest accordingly.  Over-confidence is the most important error in decision making, according to Dan Kahneman, the leading proponent of behavioural economics.  Next week’s Financial Times is not available to anyone, but diversification and risk control can be built in today, and with a soupcon of considered probability.

 Andrew Wilson, Chief Investment Officer, January 2021


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