In my last major update in November when Biden was unofficially confirmed the winner, I talked about the scenario of a melt-up in the equity markets on the heels of stimulus and infrastructure.  Today, here we are in the midst of the melt-up and more stimulus than the eye can see keeps washing ashore.  Now, we face an economy and world trying to congeal back to some normalcy.

It’s a terribly confusing puzzle to put together right now.  How will all this stimulus, boosted unemployment benefits, labor shortages, supply chain issues, debt, market support, and inflation play out?  When you look at all these factors, it’s no wonder opinions are all over the place.

We’ve lived through a low inflation world for so long, a return to inflation would be something only those over the age of 60 can vividly remember.  The dynamics involved in a rising inflation world are far different than what we’ve grown accustomed.  I was reticent to believe inflation would be our worry in the past decade, but I think it’s now fair to be concerned about it in the coming one.  I don’t expect inflation will be a straight line up, but more of a slow grind with fits and starts that could become a large problem later in the decade.

The debate of whether the high inflation is from “base effects” of using a down year, and if re-opening is the primary inflation effect that will subside or not is a heated one.  Wages have been on the rise in a manner not seen in 40 years, and this is a key area to watch.  Higher wages for more money to spend can be a great thing, and we won’t see how inflationary that will be for several more quarters.

We’ve dealt mainly with supply side economic stimulus in the past with lower interest rates, and now we are seeing more demand side stimulus like we are currently witnessing in the form of direct payments, higher unemployment benefits, social equity programs, and infrastructure spending.

I believe this transition will ultimately upset the current Wall Street applecart in a big way.  The infrastructure of the stock market itself has been transfixed around a low inflation world for about 40 years.  That means taking more excessive risk on longer dated projects.  How the Federal Reserve navigates these risks is of utmost importance.  A large policy mistake is much more likely than ever before.

I’ve long believed this bull market out of 2009 would end in euphoria and we’ve seen a good bout of that over the last 12 months.  Nobody knows when that party will end.  Perhaps there is no real hangover for quite some time?

There are some who believe we are still early in this bull market on the backs of the demand side boosters.  That may be true, but this is the first time in several years that I think it’s best to start being more cautious and ready to raise the cash levels of our clients.

The mantra of don’t fight the fed, the market will never go down in my lifetime, buy the dip is at screaming levels now.  Inflation worries could easily reverse this regime of support out of The Federal Reserve.  The amount of leverage that is deployed in a low inflation game is very high and an unraveling of that leverage if several firms go bankrupt could force large amounts of selling over a short period of time.

For these reasons we are generally avoiding more aggressive investments, and hovering around neutral with the occasional tapping of the breaks. That could change at a whim however, and as always, we have data points in the market that dictate at what speed we are driving. but I don’t believe at this exact moment the data suggests we should be slowing to a near stop.

Melt-ups tend to go higher and longer than anyone can believe.  While we are ready to get defensive, we want to still remain at the table.  We could see some outstanding numbers the next few months as the nation drops the masks.  The chances of an all-out euphoric ending with eye-popping returns over a short period are still in place.  Should we see this, I would recommend raising cash levels more significantly. We may need to grab a few years of return over the next few months.

(Past performance is no guarantee of future results. The advice is general in nature and not intended for specific situations)