Halloween is less than a month away, Thanksgiving is a little over a month away, and Christmas is just shy of three months away. All of that adds up to the fact that it’s time for our 2020-Q3 Asset Management Near-Term Outlook.
Our Three-Point Investment Philosophy
- We invest so that potential returns can complement our own labor over the long-term.
- Prudence in the short-term is the best way to gain benefits in the long-term.
- Our role as advisors is to assist in defining and executing a vision and strategies for the long-term, and the prudence with which they should be implemented in the short-term.
Four-Point Near-Term Outlook
NOTE: All information used in the production of this newsletter can be found by clicking here.
Color-coded perspective key:
- Green: Positive
- Yellow-Green: Cautiously positive
- Yellow: Cautious
- Orange: Cautiously negative
- Red: Negative
Since the bear market associated with the Great Depression, there have been four macro economic conditions associated with bear markets:
- Commodity Spike
- Aggressive Federal Reserve
- Extreme Stock Valuations
With that being the case, those are the four characteristics that we evaluate to gain perspective on the investing environment in the short-term.
The last time we wrote, estimates of the 2020 economic decline in the US pegged the contraction as the worst since the Great Depression, with a decline in GDP of -12.8%. As some of the clouds have begun to lift, those estimates have been revised to reflect a smaller contraction of -10.1%. While any improvement is most certainly welcome, the current recession remains the second worst since the Great Depression, with the recession that followed WWII taking first prize.
Another similarity to the last time we wrote, whether the economic picture continues to show improvement remains contingent upon the lifting of economic restrictions. While many restrictions have been, and continue to be, lifted there are plenty still in-place and the country remains divided as to whether that pattern should continue and the speed at which it might take place, both of which are certainly matters dictated predominantly by the numbers surrounding Covid-19 infections. In terms of confirmed cases, the numbers indicate that we reached a peak in late July, early August. In terms of deaths, we reached a peak around mid-May.
The fact that the peaks in those two numbers came at different times is interesting and there are several factors that might explain the difference: amount of testing, specifics of those who are getting infected (e.g., predominantly younger individuals, as opposed to older), and improved effectiveness of treatments, to name a few. Regardless, there is no doubt that the absolute number of deaths occurring on a day-to-day basis has declined substantially, which is a positive for our communities and potentially for the prospects of restrictions to continue to be lifted.
With the lifting of restrictions, key economic indicators have shown improvement. Payrolls continue to recover and unemployment has dropped to 8.4%; momentum in services has turned green (positive) for several countries—the US, UK, Germany, and France; and corporate profits are projected to recover next year. While good news should be celebrated, it is sobering to realize just how far we still have to go in certain respects. Sectors like education and health services, professional and business services, manufacturing, and financial services have recovered less than half of the jobs lost at the hands of the recession. Some sectors, like information and mining and logging, have continued to lose jobs. Moreover, reports are picking up about temporary job losses turning into permanent job losses. (Source)
We will always root for quick economic rebounds, but it appears that the recovery that some experience will be more U-shaped than V-shaped, while some might be so unfortunate as to not experience a recovery at all.
The story with commodities remains virtually identical to the last time we wrote: across the board, commodity prices remain at the low end of their 10-year averages. There is a high correlation between movements in commodity prices and inflation, and commodities are obviously an input cost to the economy, as well as being consumable—i.e., their role, and associated costs, are very important. Given that inflation has been below its 50-year average since 1991-1992, it stands to reason that commodity price performance might reflect a similar trend—and they have, at least in terms of not gathering steam toward a spike. That being said, we remain a long way away from a spike in commodity prices, but there are at least a few reasons that one could have a bullish outlook on inflation and commodity prices: first, what inflation there has been has largely remained intact during the recession and has recovered some of what it lost; second, oil is obviously a major factor on the commodity scene, and inventories have experienced a sharp decline, while the active rig count is at a low, when compared to the numbers for about the last decade; and lastly, the Federal Open Market Committee (FOMC) announced an update to its Statement on Longer-Run Goals and Monetary Policy Strategy that stipulated they would be more tolerant of above-goal inflation, with an eye more toward average inflation over a period of time. (Source)
Aggressive Federal Reserve
Concurrent with the update announced by the FOMC, the Federal Reserve also announced a goal of inflation running at more than 2% for “some time” and that it would be willing to keep interest rates low for years to meet that goal. (Source) This is significant when considering some of the factors already cited, but also for what it potentially means for the balance sheets of households, businesses, and governments, and the prospects for investing. From 1975 to the Financial Crisis, household debt had been on the rise, with the only reprieve coming in the early 80s. Since the Financial Crisis, the trend of acquiring debt has reversed substantially—at the time the Financial Crisis began, household debt was around 100% of GDP, but now it is 75.2%. This stands in contrast to businesses and the US government, which have both grown debt since the Financial Crisis, with government debt increasing significantly—from about 75% of GDP to nearly 115% of GDP.
As for what this means in the big picture, a substantial reduction in household debt means that individuals and families might be in a better position for consumption, which would undoubtedly be a positive for the economy. In fact, at the beginning of the year, consumption made up 68.1% of GDP, while consumption still comprised 67.1% of GDP by the latest measure—a potentially promising indication of how the American consumer has remained resilient. To compound this potentially positive angle, the substantial reduction in household debt is at least partially responsible for interest-bearing assets per household ($135.4 trillion) far outweighing interest-bearing liabilities per household ($16.5 trillion). Essentially, this points to the potential that increases in interest rates might be more akin to placing a foot on the economic gas pedal, as opposed to the brake.
It might go without saying that a government’s balance sheet being loaded with debt is not ideal, but the only way to meaningfully address that issue is with some substantive policy changes—that has yet to occur. Businesses, on the other hand, benefit from the access to cheap cash, which is supportive of maintaining operations, or even growing, especially with the challenges of the current economic environment. If businesses are able to maintain or grow during these times, then it could bode well for the stock prices of those businesses. Further, we previously established that history would dictate that we are in a time of positive correlation between interest rate changes and market performance—i.e., up or down movements in the 10-year Treasury rate results in corresponding up or down movements of the S&P 500 over subsequent two-year time periods. In addition, investing is a relative endeavor, not absolute. What we mean by this is that the determination of what might be a good investment is a matter of comparing one option against potential alternatives. As an example, the average dividend yield for the S&P 500 is 1.8%, compared to the 0.7% yield of the 10-year Treasury. The higher yield for stocks means that some will choose stocks for income purposes, as opposed to interest-bearing assets, and this helps demand for stocks, which would in turn help stock prices.
Extreme Stock Valuations
Slightly negative performance over the last three months, potentially coupled with some earnings growth, has resulted in a slight decline in the P/E ratio of the S&P 500 from 21.7 to 21.5. While this still puts the entire S&P 500 index in relatively extreme territory (partially thanks to its quick rebound, which has resulted in a positive 5.6% year-to-date (YTD) return), not all sectors, industries, or even asset classes have experienced the same positive results. As some examples, these sectors of the S&P 500 are still in negative territory YTD: Industrials (-4%), Utilities (-5.7%), Real Estate (-6.8%), Financials (-20.2%), and Energy (-48.1%). If you broaden the context, additional signs of potential opportunity exist, such as growth stocks having outperformed value stocks for about a decade now. Another way to put it to emphasize where opportunity might lie: value stocks have underperformed growth stocks. We have hit an inflection point, however, that might signal that trend is about reverse—value stocks now appear cheap to growth stocks. Granted, that ratio flipped around 2017, but growth stocks were cheaper than value stocks, or on a level playing field, for about 4-5 years prior to growth stocks outperforming. Currently, the average P/E of growth stocks among small, mid, and large caps, is 181.6% of its 20-year average. Meanwhile, the average P/E for value stocks across the same categories is only 125.27% of its 20-year average. Further, YTD performance across those categories for growth stocks has averaged 14%, while value has averaged -15.3%.
Obviously, all of the factors in the previous paragraph pertain to US stocks and there remains a great, big global economy out there, with additional markets where stocks are traded. Similar to the disparity between growth stocks and value stocks, there has been a substantial disparity for some time between US stocks and international stocks, as measured by the S&P 500 and the MSCI All Country World ex-US index. Part of the disparity in the return experience of those indices has been unique to US investors, as a strong dollar has muted, if not completely wiped out, positive returns, but valuations would indicate that another substantial part of the disparity has been absolute, not relative—e.g., European valuations are only slightly above their 25-year average, EM stocks are a hair below their 25-year average, and Japan is significantly below its 25-year average.
With the S&P 500 having rebounded so well, you might be wondering how that could be if there are some areas that haven’t recovered as well as some of the others. Well, a large part of the answer lies in Technology stocks. The technology sector of the S&P 500 has returned nearly 30% (28.7%) YTD, with online retail businesses delivering 60% returns. As a result, technology stocks now comprise 39% of the S&P 500’s valuation—this is rather staggering when you consider that the S&P 500 is broken into 11 sectors and only one of those now comprises nearly half of the entire index’s valuation.
So, while a broad look at stocks—US stocks, in particular—might reveal some warning signs, and rightfully so, there are indicators that suggest opportunity might be found if one was to look in the right areas.
In a phrase, we aren’t out of the woods yet. As is always the case, the main point of concern with investing relates to risk, which is best understood as the level of uncertainty that you will have access to the funds you need when you need them. With that as the context, we believe that there is still a substantial amount of uncertainty that remains, and that is a matter of the questions that are still unanswered. Questions as large and broad as when life will return to what we have always considered to be normal, and questions as narrow as who will be the ultimate winners and losers of the current economic conditions and at what the pace of winning or losing might occur.
Compounding the uncertainty of current economic conditions is a presidential election set to occur in about a month. From our vantage point, the uncertainty related to the election is not necessarily one of whether America will succeed or fail in the long-term; rather, it’s more a question of what the first steps will look like as we try to regain solid footing. Historically, economic success and positive performance of the S&P 500, has not been a domain exclusive to the control one party or the other—positive economic and market growth have been experienced during times of Republican, Democratic, and split control. We do believe, however, that all considerations taken in balance point to making sure that good managers are in-place to identify and seize opportunities, as specific investment choices based on solid reasoning will be key to navigating current conditions.