Stranger Than Fiction
I read countless books during the Great Recession trying to understand how we found ourselves in a ‘once in a generation’ economic collapse. My wife couldn’t stand the fact I kept delving into such heavy topics at the time. She was always bugging me to take a break and read some fiction instead. The truth was far more entertaining (and stranger) than anything an author could imagine though.
What I discovered for myself was a truism many others have uncovered for themselves. John Maynard Keynes summed it up in the 1930s by saying that, “Markets can stay irrational longer than you can stay solvent.” His quote came about after he lost a large sum of money making speculative stock trades in 1920.
This quote may help explain why we’re seeing the market climb over the last few weeks. Are the markets irrational? If so, are investors repeating the mistakes of the past? It’s hard to know for certain, but we can start formulating ideas now that we’ve had a few months of performance data to review.
Back to Basics
Financial planning attempts to answer three key questions: Where do you stand financially? What are your financial goals? How do we reach those goals? Once we answer the first two questions, we can start working towards our goals through a combination of saving and investment. A big question for savers right now is if they can expect to see their investments begin to grow again.
To answer that, I want to take a step back and focus on the fundamentals of investing. When most people think about investing, they’re thinking of the stock market. Stock selection is an important part of building a financial plan as they typically offer higher rates of returns than other investments. The media tends to focus on the stocks because of this. Unfortunately, most newsreaders focus on the growth of share prices above all. This misses the point of owning a stock.
A stock is an ownership stake of a company. Investors take on the risks associated with ownership, but also the rewards. These rewards come in the form of dividends. Dividends are a distribution of a portion of a company’s earnings which are paid to shareholders. These dividends not only provide income, but they also help determine the intrinsic value of a stock’s share price.
Put simply, the value of a stock is based on the estimated steam of future dividends. This is true even for stocks, such as those in the growth sector, that currently don’t pay dividends. This fact presents investors with a conundrum… stocks continue to rise in value despite the fact that earnings are projected to fall 22% in 2020 and 13% in 2021.
To the casual observer, there appears to be a disconnect between what’s happening between Wall Street and Main Street. If Wall Street is right, we should continue to see the market climb back. If they’re wrong, a more conservative approach may be prudent.
How this will play out in the future remains unknown. We know that the markets will eventually recover. The last few weeks have given us hope that this may come sooner rather than later. Normally, the direction of the market would have little lasting impact on financial planning models as they already incorporate bear markets in their projections. A depression could change that.
The Bull Market Returns?
Coronavirus alone did not cause the steep market decline earlier this year, though it accounts for some the lost productivity early on. The Chinese New Year holiday started January 25th and lasted two weeks. There is typically a dip in productivity due to the fact some workers fail to return after the national holiday. This year, almost twice as many workers failed to return over fears of the virus.
Weeks later, the Russia-Saudi Arabia oil war began. This happened right around the same time the media, which had previously been focused on Impeachment, turned to pandemic reporting. The stock market, which had been propped up by billions in liquidity from the Federal Reserve over the previous months, declined by over 30%.
We’re now two months into a pandemic that could last years. Despite this, the stock market has rallied in recent weeks. This seems divorced from the economic reality we are now facing. Investors and financial advisors are enjoying the current rally, though many have increased their cash reserves. Is caution still warranted now that the nationwide lockdowns are ending, or should we expect to see the markets continue to rise?
Market value always has grown over the long run. This is true even in the worst of times. There were eight bear markets between 1926 and 2017 that ranged between six months and 2.8 years in length. Market growth typically began after the economy recovered.
This is perhaps the best bit of good news during a downturn. The current market rally, for some, is proof that the forward-looking market sees better days ahead. This optimism is not unfounded. There are many other positive factors that are lifting markets.
For starters, both the Federal Reserve and the government have gone to great lengths to stimulate the economy. This is in contrast to what took place during the Great Recession. While the outgoing Bush Administration admirably broke with conventional conservative ideology to begin stimulus, politics hampered the Obama Administration’s subsequent follow up. This doesn’t appear to be as much as a factor this time around.
Congress quickly provided stimulus funding in an effort to prop up the economy in early March. The Federal Reserve has also injected liquidity into the economy as well. The Fed has also enacted near zero percent interest rates during this crisis.
With interest rates near zero, there is no better time for businesses to borrow money for future projects. Additionally, this has also created a condition where low bond yields are pushing investors towards the stock market as an alternative. Basically, there’s cheap money flowing with nowhere to invest.
The stock market has also seen growth because of the recent corporate tax cuts. This isn’t just due to the lower tax burden for companies. Just as many had predicted, a large portion of companies began stock buybacks after the tax cuts. This creates a simple supply and demand condition for the remaining available shares.
Finally, the pandemic itself is behind some of the growth we’re seeing in the market. Technology has blunted the impact of Coronavirus unlike any previous pandemic in human history. Amazon allows us to safely social distance while shopping. DoorDash delivers food to our front door. Zoom lets office workers continue to stay in touch. The tech sector is a major factor behind positive market returns because it is helping us overcome many of the worst aspects of the virus. Frankly, there has been no better time in history to be alive during a global pandemic.
On the other hand… we’re still in a global pandemic. Worse yet, the current pandemic may have only just begun. As of mid-May, over 90,000 Americans have died as a result of the disease. Over 36 million have lost their job in recent months, with over 40% of those losses predicted to be permanent. The U.S. GDP declined by -4.8% during the first quarter of 2020. Looking forward, we have Q2 GDP projections at -40%.
If these numbers sound bad, it’s because they are. While the human toll can never be quantified, the economic impact continues to be one for the record books. This economic data stands in stark contrast to the market news we’re seeing. The ‘Buffet Indicator’, which compares market values to GDP, shows that stocks are at a historically high overvaluation.
The value of the stock market is over 150% of our current GDP estimates. In comparison, equity valuations during the Great Recession were near 70% of GDP. This is one of the most overvalued markets in the history, second only to the 1999 tech bubble. Making matters worse… This was true before the pandemic hit.
Looking back through my past newsletters, it’s apparent that the warning signs were everywhere last year. Despite that, we continued to get rosy predictions from both the Fed and the Trump Administration. On September 6th, 2019, Federal Reserve Chairman Jerome Powell said that the Fed was not forecasting a recession. Ten days later, the overnight lending rate between banks spiked from 2.5% to 8.5%, which prompted the reserve to begin injecting liquidity into the economy. This was roughly six months prior to the market correction. The repo process continues to this day.
What I am saying is that this economy was on shaky ground far before the lockdown began. We had seen policy slowly moving us towards an inevitable correction for some time. There was the late 2018 bear market. Bond yields were signaling recession for over a year. Tariffs, which remain in effect to this day, continue to take a toll on the economy.
Jerome Powell’s prediction that there will be no recession just days ahead of the collapse of the overnight lending market seems to be on par for the course lately. Powell appears to have maintained a semblance of independence until sometime in 2019. Unfortunately, he seems to have capitulated to political demands that required he now spin economic realities.
During Powell’s most recent television interview, he claimed that he did not see a depression unfolding in our future. He went on to claim that the Fed had plenty of ammo left to fight the impending recession. There’s no way to verify the first claim until after the fact, but the second claim is clearly false.
Interest rates have been kept artificially low for years now, which are in part responsible for the overheated stock market. There is nowhere left for rates to go at this point. The Fed could reduce capital requirements for banks, but the September liquidity crisis showed that banks are unwilling to put themselves in the same position they were prior to the Great Recession. Most likely, we’ll see the Fed continue to buy treasuries (or more) during repo auctions, though this will only serve to keep asset prices overvalued.
Some of the other remedies to stimulate the economy are also off the table. We’ve seen at least one stimulus package passed by congress. It appears unlikely another will pass. We could further reduce taxes, though the recent cut makes that unlikely (Germany, in contrast, is using their budget surplus to effectively manage the pandemic). The ideas that have been presented lately appear to follow the same playbook we’ve seen over the last few years.
Economists warned us about these polices some time ago. The current ideology we are following has been tried before. History shows that there is often a momentary economic spike that comes at the expense of the future. This time, it’s coming with a three trillion-dollar price tag.
Normally, a quarter end investment review like this would have been finished weeks ago. That hasn’t been possible given the extreme swings both with the market as well as the world. Now, it appears that we’re about to open the economy back without any lessons learned.
America seems to have spun into two diverging realities. Every morning, I spend an hour or two doing market research. For the most part, financial newsreaders and industry professionals seem to believe that this time is indeed different and that the markets will quickly recover.
On the other hand, the pessimists make a compelling case. Record market valuations seem absurd given the reality we’ve been living through. The Fed appears to have become politicalized by the same people who were calling the pandemic a hoax just months ago. Just as these leaders failed to prepare the nation for a pandemic, tax and interest rate cuts left us unprepared for the reality of a recession.
While I am no pandemic expert, I do understand how compounding numbers work. We may have flattened the curve enough to prevent our health care industry from being overrun, but what we haven’t done is to put the necessary protections in place going forward. Without a coordinated response, there seems little reason to expect that opening the economy is enough to begin recovery.
When my father-in-law tested positive for Coronavirus last month, I quickly realized how difficult this virus would be to overcome. And by overcome, I don’t mean just physically. While Steve has gone on to make a full recovery (he’s the kind of guy who mountain bikes and plays tennis during the summer heat here in Arizona), his mild case of Coronavirus was anything but ‘mild’.
The fact that he managed to get tested so early on is surprising. To date, U.S. Coronavirus testing lags behind every major developed nation. My family had contact with my father-in-law while he was infected. We developed symptoms afterwards yet were unable to get the antibody tests that could clear us for normal life again. This is happening across the nation.
People will not return to normal life until they can be assured their families are safe. For those lucky enough to remain employed, many are doing so while working from home. Couples are now fighting over home office space with screaming kids in the background. Homeschooling, home cooking, home detention… Americans are now wearing so many different hats that it’s hard to see how they can be productive employees.
The two diverging truths seem to follow ideological lines rather than facts. The thing about a virus is that it really doesn’t care which truth you believe in. Science is funny that way. Still, humans have always been able to bend reality to their will… at least for a time. Keynes learned that the hard way when he discovered the markets can remain irrational longer than he could remain solvent.
The best path forward is one of trepidation. I will continue to recommend that clients remain invested in diversified allocations, though I will avoid unnecessary exposures to additional risk while remaining cash heavy. This may be at the expense of potential gains in the near term, but this seems prudent given the available information.
At the start of the pandemic, client portfolios were already positioned more conservatively than planning models suggested. After the initial wave of declines, capital losses were harvested from high risk funds (such a small cap, emerging markets, etc), which created tax savings that will bolster future returns. Portfolios were rebalanced at the end of the quarter with no allocation or fund changes being made at that time.
Going forward, I will begin to reallocate portfolios based on the new realities of the economy. One area that will see increased weighting is the technology sector as it appears these investments will be vital to continued social distancing. This rotation will be done slowly, as valuations are simply too high at this point.
The next few weeks will determine the direction of the stock market. With the economy opening, we’ll be witness to which reality is ‘reality’. The Coronavirus could turn out to be nothing more than the flu. The media could be in on the hoax of the century. Politicians ordering lockdowns could truly be tyrants.
Or the virus could simply ignore all of that.