Investor Commentary Q3 2020
“What’s Past is Prologue” –William Shakespeare, The Tempest
Last quarter was remarkable in that it marked the time when we succeeded in recovering the pandemic-related losses. While September was lackadaisical, July and August rewarded our Q2 rebalancing effort. The reason the market rallied had to do with massive amounts of cash sitting on the sidelines, a psychological fear of missing out, and the realization that certain companies and sectors were benefitting from the pandemic response. It even sparked a new trading acronym, work from home stocks (“WFH”). This includes companies like Amazon, Home Depot and even Gulfstream RVs. The housing market also benefitted from record low mortgage interest rates. As a result, investors and homeowners are entering the fall feeling flush.
The Fed has boosted the amount of money in the economy by 40% in the past 6 months. This liquidity flowed into financial markets fueling gains. They will know this cash has overflowed to reach the real economy when the consumer price index (CPI) rises. They do not know how much stock price inflation is needed before there is a spillover effect so they have committed to massive liquidity for another two years which will create a tailwind for investors. In the meantime, two major unknowns lie ahead of us: the Presidential election and the path of inflation.
There has been a lot of discussion about whether Donald Trump or Joe Biden would be better for the stock market but with the election system under question and coronavirus adding an unknown to the trajectory of voter behavior, what we should be asking is: what happens to markets in times of volatile political transitions?
Our most recent and relevant analogy would be the 2000 election. With no clear winner from November 7 to December 12, 2000, the US was uncertain of whether the next President would be George W. Bush or Al Gore. The question centered on who got Florida’s 25 electoral votes, In a very technical legal decision, the Supreme Court ruled that the state should go with their original estimate that Bush won. Later recounts indicated that Gore would have won the state. However, this was irrelevant because on December 12 Al Gore conceded the election indicating that it was bad for the US to be directionless and without a clear leader.
It is easy to project parallels to the upcoming 2020 election. So, what happened to the stock market during this uncertain time? In a flight to safety, the S&P 500 fell 8.17% in the 3 weeks following the election only to rally back to a 4.26% decline while long bonds rallied 4.24%. Interestingly expectations of volatility dropped as the VIX index lost about 8%. Equities regained their prior levels by inauguration day only to collapse by 40% over the subsequent 2 years because of the dot com bust which was not election related.
What can this teach us about investing?
“In the short run the market is a voting mechanism but in the long run it’s a weighing mechanism” – Warren Buffet
We benefit from maintaining emotional stability in the face of volatility. Do not panic in the face of dire news coverage. Ultimately any political uncertainty must resolve which should enable markets to retake any losses. Keep your eye on the long-term. Myopically focusing on the election may have blinded investors to the larger problem of liquidity imbalances embedded in tech. Sound familiar?
What will remain in the wake of Covid-19?
In response to deflationary forces governments have been pumping trillions of dollars into the advanced economies of the world. This is on top of almost 10 years of monetary growth since the Global Financial Crisis. Why has this deluge of money, not produced increases in consumer prices and wages? The answer is twofold. First, circulation of cash has slowed. Consumers, shocked by the debt crisis, moved to pay down debt and save while corporations used money to buy back their own shares; a proxy for a lack of investment opportunities. Secondly, wages have been suppressed due to a decade long influx of labor from China and Eastern Europe. The cash injection did succeed at fueling asset price inflation in the form of a rising stock market in rising home prices.
Looking forward, I could easily see these relationships inverting with the real economy inflating while asset prices “run to stand still” on an inflationary treadmill. In the real economy, less offshoring of workforces could lead to domestic workers having more wage bargaining power. We all gained a newfound appreciation for essential workers that were seemingly overworked and underpaid. Labor markets are affecting the political landscape in the US. Tech has reduced prices, but lower competition could lead to price increases when the economy expands. Select large companies will be able to pass along higher costs to consumers especially if they seek to expand margins to offset slower growth or as a buffer to the cost of increased resilience and inventory in their supply chains. For more localized businesses, contact intensive services like dentists and restaurants will cost more because of reduced capacity.
At the same time the baby boomer generation is retiring and the fact that they did not have many kids means that there won’t be as many taxpayers to fund their retirement in terms of Medicare and Social Security. One rapidly growing disease that reflects seniors is dementia. Unlike cancer or heart disease, it is not fatal, but it is very expensive to treat. Combine that with the increasing life expectancy for retirees and you have a massive number of people who will be dependent on the medical system with very few young people to pay for them. This will cause an increase in taxes which is also inflationary.
In response, we could see Central Banks reduce the amount of money in the economy and the tide that lifted investors’ boats would recede, leaving them in uncharted waters as higher interest rates compress stock valuations and diminishing corporate share buybacks remove this supporting force (Yardeni research estimates that share buybacks and dividends account for 4.44% of the total S&P 500 return).
What does this mean for investors?
You can be rest assured that we have been planning for these long-term hurdles in a few ways. We are looking towards assets that exhibit the growth needed to offset this pressure on profit margins. Also, the massive monetary base is going to fuel pressure on fixed income portfolios but there is money still to be made -- non- US dollar bonds which is a very pragmatic way to profit from monetary inflation.
As Covid-19 continues to hamper the economy, where do we invest from here?
There is a Confucian proverb that says, “fool me once shame on you fool me twice shame on me.” The way I am thinking about the current market is that we have gotten a “do-over” from the Covid collapse. Those who choose not to learn from history are doomed to repeat it; what did we learn? First, we learned that volatility is going to be higher. Consequently, the portfolio for this season is shaped more barbell, where safe assets are extremely safe and risky assets are riskier than normal. We have already started implementing this thesis in our portfolios. For example, we are currently testing new high risk-high return strategies employing advanced options strategies that we have developed in conjunction with professionals affiliated with Chicago Board Options Exchange (CBOE).
I welcome your comments, updates, and inquiries.
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