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Worlds Apart
Plus August Market Report

John Gorlow | Sep 17, 2020
CardiffPark_Perspective

August is often a sleepy month for stocks. Not this year. In August, stocks surged to their fifth monthly gain in a row. The MSCI World Index of stocks in developed nations jumped 6.68%, its sharpest August rally since 1986.


The broader All-Country World Index, which includes emerging markets, gained 6.12% in August, its best run stretching back to 1988.


As for the broad US market, the S&P 500 Index reached a new high, ending the month with a 7.19% return and 9.74% YTD gain. This was the best August for the index since 1986.


Apple, the largest stock in the S&P 500, was also the largest contributor to market gains, up 18% in August. The company surpassed $2 trillion in market value for the first time. The iPhone maker is joined at the top by Microsoft, Amazon, Alphabet and Facebook, which together make up more than a fifth of the S&P 500. Together, these companies account for nearly a third of the gains since the market rally began at the end of March.


The Nasdaq composite, meanwhile, reached a new milestone to close at an all-time high. For the month, the tech-dominated Nasdaq increased 9.7%, and was up 32.07% YTD.


The Dow Jones Industrial Average gained 7.57% in August, but finished the month down -0.38% YTD.


Happy, Wary, Puzzled


Who could have anticipated that the S&P 500 and Nasdaq would set new highs in August, so soon after the sharpest US economic contraction in history? Repeating a refrain heard over several months, the market seems disconnected from the broader underlying economy.


And yet there are plausible explanations for the market’s behavior. In late March, central banks set the stage for a surge in asset prices as they moved aggressively to ensure liquidity with interest rate cuts, lending guarantees and bond purchases. Another factor behind the explosive market may be that investors are pouring their money into a vision of the future in which a home-centric economy dominated by technology becomes the norm and not the exception.


To get a handle on tech’s contribution to the market rally, compare the broad-based S&P 500 index with the tech-focused Nasdaq 100. The Nasdaq has risen 32.07% through the end of August, while the S&P 500 returned just 9.74%. Within the S&P, the performance of the so-called “FAANG” tech darlings—Facebook, Amazon, Apple, Netflix and Google/Alphabet—offset lesser performances by the 495 other companies in the index. Four of these companies are simply on fire: Amazon is up about 70% this year, Apple is up almost 66%, Netflix is up 65%, and Facebook is up 45%. These four stocks recently accounted for close to 25% of the S&P 500 market cap, a level of concentration rarely seen in the benchmark index. Without the full contribution of their returns, the return from owning the S&P 500 equal-weighted stock index—including dividend payments—would have been negative 2.27% YTD through August.


The market rise reflects two forces, reports DeAnne Julius, former member of the Bank of England’s Monetary Policy Committee (Financial Times, 20-August 2020). The first is Covid-19, which literally drove people into their homes and forced them to use technology for school, work, entertainment, shopping, and home delivery services. “The FAANG companies benefited disproportionally from this surge in demand as their production is scalable. Much of it could also be delivered by employees who themselves worked from home. The rise in their share prices reflects this,” she says.


The second driver of rising markets, Julius writes, is that markets are forward looking. The fact that GDP shrank during Q2 “is less interesting to financial advisors than the fact that during May and June it expanded.” In other words, “recovery began in May and accelerated in June and tacked on additional growth in July and August as lockdown restrictions were eased.” E-commerce has benefited greatly from this growth, increasing 37% in the second quarter and recently accounting for more than 20% of total US retail sales according to latest US Commerce Department estimates. 


Julius believes we have entered a new period of disruption as the world adjusts to the realities of Covid-19. This disruption is likely to continue regardless of vaccines and treatments. “Governments should ease the pain of this disruption with supportive fiscal and monetary policies, but they should not try to slow it down. The hopeful market message is that one lasting consequence of Covid-19 may be the rejuvenation of productivity growth that eventually spreads far beyond tech.”


Everything is Not All Right


Covid-19 handed the tech industry a golden opportunity for growth. But for many other industries and people, the pandemic has delivered nothing but misery.


Entire sectors of the economy are under tremendous pressure. Oil stocks are in a terrible place. Retailers are going bust in droves. Bank stocks are down 30% this year in the US, and worse in Europe. Travel and tourism stocks are in a hole. Smaller company stocks have rebounded, but only back to where they stood in January 2018. Brooks Brothers, Neiman Marcus, and JC Penney have entered bankruptcy proceedings. Meanwhile, widespread unemployment, accelerating closures of small businesses and housing evictions are pairing up with extreme weather events, devastating fires, and the possibility that the pandemic will combine with a bad flu season for even deadlier outcomes. These on-the-ground realities only serve to deepen uncertainty and fear.


Dark Economic Cloud Over Cities and States


Another growing concern is the increasingly serious situation facing state and local governments. State and local governments already reduced spending at a 5.6% annual rate in the second quarter, and additional cuts are likely to be deeper. Many anticipate that deeper spending cuts to come could undermine any fragile US economic recovery.


Federal lawmakers have been unable to agree on how much state aid to provide, if any. But without additional federal aid, state and local budget shortfalls could total roughly $550 billion over the next two fiscal years, and cities and towns could face shortfalls of $360 billion. Taken together, that’s a staggering number approaching nearly $1 trillion.


To be clear, the Muni market as a whole remains a relatively safe port in the world of bonds. Since 1900, only one state has defaulted (Arkansas in 1933). But the longer the Covid-19 crisis continues without additional aid to state and local governments, the more significant the ripple effect is likely to be across the US economy.


During the Great Recession from 2007 to 2009, deep cuts in state and local governments contributed to slow growth and a labor market that took more than six years to recover. This time the damage could be far worse. Many states are paying for high unemployment and health care costs while simultaneously experiencing a precipitous decline in sales taxes, personal income taxes, and corporate taxes. Because nearly all states are required to balance their budgets, officials will be forced to stop the bleeding by tapping emergency funds, raising taxes or cutting costs, including state and local jobs (The New York Times, 15-August 2020). These cost-saving could shave more than 3 percentage points off US gross domestic product and costing more than 4 million jobs, says Dan White, head of fiscal policy research at Moody’s (Barron’s, 31-August 2020).


Fed Chair Jerome H. Powell and others have added their voices to calls for state aid, warning that a large number of state job cuts will hurt the economy’s ability to recover. “In fact, that’s kind of what happened post the global financial crisis,” he told Congress in June.


Not surprisingly, Moody’s Investor Service has lowered its outlook to negative on all municipal bond sectors except for housing-finance agencies and water, sewer and public power. Meanwhile, among small issuers of municipal bonds, defaults have reached their highest rate since 2011, according to Municipal Market Analytics data. The market is seeing increasing distress in senior living, student housing, hospitality and hotels, and project finance.


What are the implications for investors? Tax-exempt municipal bond funds have notched 17 consecutive weeks of inflows since mid-May, as the Federal Reserve has made moves to boost confidence in the market. Despite an uptick in defaults, municipal bonds tend to default less than corporate bonds. And according to market experts, some fund managers see big-name borrowers who have good relationships with creditors as a good long-term buy even if their bonds are at risk of a short-term downgrade.


Guarded Optimism, Aided by the Fed


Despite all the bad news, investors focused on the bright side in August. The spread of the virus and the number of deaths is slowing. Businesses are reopening. A vaccine is closer. Expectations for corporate profits are improving, jobs are being added at a modest rate, and state unemployment rates are beginning to decline. The economy is improving, even if the recovery is lukewarm. The Fed continues to issue reassurances and various forms of support. All this contributes to growing optimism among some investors.


Seen another way: “It seems to me that markets have decided this economic environment is the best of both worlds: enough economic recovery to support corporate earnings and prevent a substantial recession, but not so much that the Fed would have to raise interest rates and tighten monetary policy,” said Scott Clemons, chief investment strategist for private banking at Brown Brothers Harriman. And with a potential vaccine on the horizon, Goldman Sachs has upgraded its outlook for growth in 2021.


Many would like to see lawmakers overcome their differences and open the purse-strings to provide aid to states, struggling small businesses, and those hardest hit by the pandemic’s economic carnage. That is unlikely to happen during this highly politicized election season. Barring that, the Fed has certain limited tools at its disposal, including unleashing the municipal liquidity facility or main street lending facility. The Fed could also depreciate the dollar to help US exporters. Some believe these measures could, and should, be implemented if needed to fend off a deep bear market. 


Warning Signs of Market Exuberance


If you’ve watched the stock prices of companies like Zoom and Peloton and Tesla climb to stratospheric levels, you may be thinking “This is a bubble in the making.” For an investment bubble to occur, there has to be “a widespread belief that a new paradigm has taken hold requiring an adjustment in valuations far beyond what previous fundamentals would imply. This belief needs to engage the imagination of investors beyond Wall Street, and there must be plenty of capital available to chase stock prices higher. The Covid-19 crisis has unlocked all three prerequisites,” concludes Ben Levisohn (Barron’s, 14-September 2020).


Bubbles disproportionately benefit some companies over others. Zoom jumped 41% in a single day after reporting sales that more than quadrupled over the previous year. Zoom stock, having zoomed 465% in 2020, is now worth more than $100 billion. Peloton has a market cap of $25 billion after gaining 209% this year, as its stationary bikes replaced gym memberships. Zoom trades for 50 times 2020 sales, and Peloton, 9.3 times. Both are priced as if future growth is unlimited—a risky bet, especially if the post-virus world looks not all that different from the previous world. “New-era thinking is everywhere,” says Rosenberg Research’s David Rosenberg. “But there are no 'new eras.'”


If the current market is in a bubble, BTIG capital market strategist Julian Emanuel offers potential scenarios that could make it pop. He points out that a viable vaccine could cause investors to choose economically sensitive stocks over those that benefit from everyone working from home. Interest rates could rise, causing financial stocks to rise and bloated technology and communication service sector multiples to contract. Continued tensions with China could also cause problems for high flying tech stocks, as could antitrust lawsuits.


We’ve seen brief glimpses of what happens when optimism over economic momentum starts to improve and bubbles are about to be deflated, says James Mackintosh, (Wall Street Journal, Wednesday, 19-August 2020). “For a few days in early August, the pattern was of rising bond yields, a choppy fall back in growth stocks, outperformance by the worst-hit shares and lowest-rated corporate bonds, gold falling and European stocks beating the US.” And the capper: “This could, of course … end when reality intrudes on prices stretched too far into fantasyland.”


The market was tested again this month. In one seven-day period in September, $1 trillion vanished from the biggest US growth stocks. Of course, whether or not this is a bubble can only be known retrospectively. But we see clear signs of excess; notably, the S&P’s forward price/earnings ratio is back to where it stood in October 1999, just months before the peak of the dot-com bubble. 


Some argue that calling this market a bubble is wrong, because the forces that created the current conditions could remain with us for some time. But other factors are in play that encourage risky investor behavior, says Ben Levisohn (Barrons, 14-September, 2020).  “Near-zero interest rates have encouraged investors to pay up for growth, while some retail investors, starved for something to bet on in the absence of professional sports, have turned their attention to stocks, trading through online brokers like it’s 1999.”


Bubble or not, markets can shift direction suddenly and without warning. The current environment is no exception. Wolfe Research strategist Chris Senyek cites a possible deterioration in the economy, an increase in Covid-19 cases, and Congress’s failure to pass another fiscal-relief package as ways in which the technology and communication stock party might end. The November election, too, could derail stocks. On the other hand, he and others point out, if the economy grows faster than expected, investors could bail on tech to buy more cyclical issues.


Retail Investors Flocking to Stocks


You may recall the mood before the housing bubble popped. A hair stylist owned multiple properties with easy-to-come-by mortgages; entire subdivisions in the middle of nowhere sold out before they were built. Everyone wanted in on the speculation game. Many confused this with investing.


Today we’re seeing a similar gold-rush mentality. The current market is driven more than usual by “retail investors … flocking to equity markets as an unrelenting five-month surge in valuations suggests stocks are immune to the damage being inflicted on the economy by the Covid-19 pandemic” writes Mohamed El-Erian (Financial Times, 2-September 2020).


Retail investment sites, such as Robinhood, have seen an incredible surge in subscribers over the past 5 months. These are people looking for quick profits with no real market knowledge or trading history; some engage in day trading after being furloughed at home or laid off from work. The problem is, says El-Erian, that “This seemingly endless rally in US stocks could leave the impression that prices are endorsed and supported by the entire professional investment community. After all, despite the vocal concerns over valuations having split from corporate economic fundamentals, few fund managers have been willing to challenge the market by placing outright shorts.”


James Montier of Boston-based asset manager GMO, is among analysts who hold the prevailing view, going so far as to call US valuations absurd. “The US stock market looks increasingly like the hapless Wile E. Coyote, running off the edge of a cliff in pursuit of the pesky Roadrunner but not yet realizing the ground beneath his feet had run out some time ago.”


GDP Math Shows long Road Ahead


“Even if the US economy performs poorly in September, third quarter gross domestic product is going to look very good. And even if it does great, the economy will still be in a deep hole,” wrote Justin Larhart (WSJ, 3-September 2020).


That sounds like a paradox until you look at the numbers. The Commerce Department reported that real gross domestic product (GDP) contracted by negative 31.7% on an annualized basis in Q2 2020, but it ended on a high note. It continued to contract in April after March's slump, but then turned a corner and expanded at a dramatic 71% rate in May and 95.4% rate in June. July figures showed an additional 26.1% annualized rate of gain. IHS Markit forecasts that the economy will contract slightly in August and September, resulting in estimated Q3 annualized growth rate of 28.7%. Sounds good, until you recognize that what we’re seeing is a shift from disaster to improvement, now with slowing momentum.


Whatever the reported outcome, this number will be politicized. The third quarter GDP reports comes out on October 29, just five days before the election. But keep in mind that precipitous drop on the left side of the “V.” To put the bear market in perspective, Lahart points out that it would take an 46.4% bounce in the third quarter to get back to even with the first quarter. And to get back to even with Q4 2019, before the Covid crisis hit, the economy would have to grow at a 54.15% rate. Though many believe the worst is over, we are many quarters if not years away from full recovery.


Remember How Markets Work


At times like this, it may seem the market is divorced from reality. But the market is always forward-looking, pricing in new information to set stock prices. This is what an efficient market does. It aggregates opinions from millions of buyers and sellers to set prices. New information and events, anticipated news, or reaction to announced news all contribute to investors’ perceptions of a stock’s value. It is always a dance. At any given point in time, some stocks will soar while others languish. Right now, we are seeing many novice investors flock to stocks that soar. For the rest of us, it is wise to recall proven market truths:


Market timing is a hollow strategy. The financial media reinforces the misconception that market timing is a viable strategy. We will never stop hearing news of market timers who made the right moves at just the right time. These stories encourage investors to believe that higher returns can be achieved without incurring higher risk. When market timing schemes work, it’s due to luck, not skill. It is not a reliably repeatable strategy. But many investors prefer to believe in something that’s impossible but plausible over hard evidence that may dash their hopes. Focus on your plan. For best long-term performance, stick to a proven strategy and remain invested through up and down cycles. Read our website on Market Timing to learn more.


Diversification is your friend. The active-versus-passive debate has long been settled. One hundred years of deeply analyzed data provides a clear roadmap. For the best long-term portfolio performance, investors should allocate funds to low-cost index funds and ETFs and diversify across multiple categories and asset classes. In this way they will achieve market rates of return with no more than market levels of risk. And they will do it for very low cost. Charles Ellis of Greenwich Associates, a long-time passive-investing advocate, offers this simple advice: “Don’t play games with trying to beat the market. Play it down the middle. Don’t expect to be able to do something clever and imaginative. Play it safely. Invest sensibly. Don’t try too hard. Be a long-term investor … Try to avoid mistakes.” He compares passive investing to driving a car safely: “I don’t want to do clever dodging in and out of lanes. I want to be sensible … to get to my destination, whole, happy and relaxed.”


The best portfolio is one built around you. Every investor has unique life circumstances and needs. A well-designed investment portfolio takes into account age, income, spending, assets, knowledge of investing, comfort with risk, interest in investing, access to information and decision-making. All these characteristics add up to your own personal investment style and portfolio. It requires disciplined thinking to achieve real insight and understanding. What’s the right investment plan for you? What are you trying to accomplish? What is your time horizon? What is your risk tolerance? During times of stress, it can be difficult to stick to strategy. We do our best to help you follow your own carefully constructed plan and not make hasty changes. A long-term, disciplined strategy is your very best tool for success.


If you have questions or concerns about your portfolio or asset allocation, contact me. I am here to help.



Regards,

 
 
John Gorlow
President
Cardiff Park Advisors
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jgorlow@cardiffpark.com

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