The noise has been deafening over the past several months. So much so, that it is difficult to know what to think. Is the economy dead, or reviving? Is COVID out, or coming back? Should the stock market follow the news, the economy, or some semblance of both?
The economy of the United States is firmly in the hand of the people and their comfort with the state of the Coronavirus. Ask yourself the following questions:
Let’s first take a look at how investors are feeling. There is no question that they are queasy. The 12-month rolling average of stock funds is on a record pacing outflow. Through July over $231 billion has been pulled from both mutual funds and ETF’s. Being comfortable in the market is not usually a recipe for success.
How has the market been performing through these sales? If we look at just the price performance of the S&P 500, then we can very quickly see that these investors were on the wrong side of performance since the end of March, when “shutdown” was the word of the day.
But that really doesn’t tell the whole story. The S&P 500 is made up of 500 different companies. They are very different in terms of how they have responded in this pandemic. The performance of these stocks has followed. As the following chart demonstrates, the largest of the companies have outperformed. The critical question is whether their performance was based on their size or based on their earnings? Putting money into an index fund will necessarily increase the number of shares of the bigger companies that are getting purchased. Will this provide excess performance in the future just because they are big companies? It is here that one should be skeptical.
Second, let’s take a look at what the major economic data is telling us.
The Federal Reserve is really the biggest story from an economic perspective. When COVID hit, they emptied out their wallet and started printing more and more money. The M2 money supply has risen to a point that we have never seen before. This is a measure of cash in the system. Clearly in times of strife, it is good to have additional cash in the system. The main cause of the Great Depression in the 1920’s was that the Federal Reserve and the banking system were not lending money out but contracting money. This made it very difficult to get the economy back on track. Our Federal Banking System leaders are great students of history and are aware that more cash is better right now. Our political system also got in the game with the introduction of a stimulus plan that added up to over $6 TRILLION. (on a side note, that is a ridiculous amount of money in an economy. The US has the largest economy in the world, coming in around $22 trillion per year. We just added 25%+ to this economy in CASH? They are also talking about another stimulus in the works.)
Clearly the general public who is selling their stocks into this rally do not understand the power of the Fed and what this cash is doing. Markets do not fall rapidly because people want to sell their stock, market falls rapidly because people HAVE to sell their stock. Why would people have to sell their stock? It could be leverage, liquidity, or a host of other reasons. When the Federal Reserve opens up their window and says come and get it, I have cash for all occasions, then no one needs to sell their stocks. They can always just borrow more money.
But the economy has taken a hit, no question. The biggest impact can be seen in the unemployment rate: This is not the kind of chart anyone wants to see. The bad news is that 7.9% is unacceptable for an economy like the US. The good news is that we seem to be headed in the right direction. The big caveat is that we do not know how fast we can get COVID behind us and bring the travel, leisure, and hospitality industries back into full swing. Quite a bit of the noise we hear are around the conflicts around government policy and purported business policy. While these conflicts are necessary to bring out all information on both sides, they make for a very uneasy public not knowing who to believe.
Overall GDP has not fared much better, as it has also taken a massive hit, but consumers do not eat GDP. They are only concerned about their circumstances. There are many who have been able to take advantage of this economic disruption. Online sales purchases, delivery services, technology services, and health care services have all been forced to do things differently. They have arguably come out on top.
The one real bright spot for consumers has been the real estate market. With the plunging of the mortgage rates to sub 3% level, affordability has once again jumped. This has caused some very interesting dynamics. The number of buyers who are now willing to spring into the real estate market has increased, however, the sellers concern for letting potential COVID carries through their house, has limited the supply on the market. The inevitable result is that the demand has exceeded the supply and house prices in the middle markets have soared dramatically.
Anecdotally, a realtor I know, just put a house on the market last week. They had an open house on Sunday, with over 20 buyers coming through and had 6 offers by Monday night, all over list price. Each real estate deal is a little different, but this story is not unusual in 2020.
We have loose money and exceptionally low interest rates. That generally takes us to a discussion of the US dollar. Will it strengthen or weaken? With the 10-year chart below, you can see we have been on a long-term course of a strengthening dollar. This is good for US consumers in that our money buys more on the global stage. However, as you can see there has been a rapid spike beginning in April of 2020 when the stimulus program was initiated. As mentioned earlier, we just created 25% of our economy in cash. While it makes us feel good in the short run, it keeps people paying for things they need – it eventually ends badly. You will begin to hear the phrase “there is no free lunch” quite a bit in the coming decade. Throwing more cash in the system does not create economic value. It borrows from future value and brings it into today. It will eventually need to be paid back (in the form of added taxation) or it will need to be inflated away.
Buyers of the US dollar know this. The only thing that can really help us is the “relative” conversation. Should other countries increase their stimulus on par with the US, perhaps we will not lose ground with our currency. So far, this does not seem to be the case. The US is clearly the stimulus winner, with more in the works. That does not bode well for the US dollar.
So where does all this take us? From a high level, it is pretty clear that there is still a lot of value in stocks, mostly those stocks that did not take advantage of the 2020 rally. If one just looks at the top 20 mega cap stocks, then yes, we would be concerned as well. Small and mid-cap stocks have not participated much and still maintain some value.
International stocks are looking very safe. The valuation continues to be inexpensive. Any unexpected growth will bring significant upsides. The currency also will be a tailwind if current policy maintains its direction.
Commodities will also be added to the table as we move forward. With government bonds in the “less than 1%” camp, and the added money printing, the commodity pool is a much better risk return ratio with assets in the next 36 months.
As always, please do not hesitate to contact us if you should have any questions.
October 9, 2020