This post is sent with the sincere hope that you and your family are healthy and safe, and that life is returning to somewhat normal as we all enjoy the summer with our loved ones. We have been back in the office since the middle of May and are available to you for anything you need.
As we moved from spring to summer in the 2nd quarter, the economy slowly began to open up and rose from its worst levels. Yes, recently we have seen an uptick in COVID cases although deaths have continued to decline. It’s not clear whether this uptick is due to an increase in testing, an increase in human-to-human contact, large gatherings of protesters or something else. Either way, the fact that COVID-related deaths have continued to decline is good news.
The 2nd quarter saw a big resurgence in asset prices. Not because there was any real improvement in economic activity as huge levels of unemployment remain, but because the Federal Reserve effectively became the credit market and began buying bonds outright from private issuers (irrespective of credit quality). This is new territory and effectively eliminates market-based pricing, which is an important indicator…of everything. Any default by issuers of Fed-bought bonds will likely be papered over by printed money.
In this new economy, whenever there is adversity, the Fed simply steps in, drives interest rates to zero, expand its balance sheet by buying bonds (with money it doesn’t have, but creates) – and the riskiest of investments, such as Tesla, go through the roof. Conservative investments languish. In effect, the Fed, through policy, has punished cautiousness and forbearance, and rewarded recklessness. Such a world is a difficult one for conservative asset managers because financial analysis has not mattered, and the value received for investment dollars has not been important for many investors.
This policy of punishing cautiousness and rewarding speculation has shown up in the broad economy as well. Savers and risk-averse investors have experienced a declining standard of living and real wealth eroded by inflation. Speculators and the imprudent have been rewarded handsomely. The monetary policies of the Federal Reserve have worked wonders for the billionaire class but have not improved life for the average family. According to Statista, U.S. billionaires [643 of them] saw their wealth surge 20% or $584 billion since the beginning of the pandemic, the same period of time 45.5 million Americans filed for unemployment.
The level of inequality is also highlighted by the fact that U.S. billionaire wealth increased by over two times as much as the federal government paid out in stimulus checks to 150 million Americans. All of this provides evidence of a fundamental flaw in our economy. As such, it is hard to project what the future has in store politically, economically and across investment markets. These are the big factors we see:
- In the very near term, markets will trade nervously in response to a second wave of the pandemic and the looming fiscal cliff. While the pace of reopening may indeed slow, there is little appetite for another round of extreme lockdown measures such as those implemented in March. Moreover, the rest of the world is much further along than the US in opening their economies.
- Congress is highly likely to extend more fiscal support for households and firms. Around the world, fiscal and monetary policies are likely to remain extremely “accommodative”, meaning ultra-low or negative interest rates, and heavy interventions in markets by central banks.
- Fiscal stimulus is much higher now than it was in 2008.
- There are high levels of cash on the sidelines and many institutional investors are looking to get back in.
- Most of the job losses were across temporarily furloughed workers. As lockdown measures relax, the hope is that most of these workers will return to their jobs.
- The US dollar has likely peaked, which has all sorts of investment implication…namely a boost to commodity prices and foreign asset prices over the longer run.
- Bond yields will only rise significantly when inflation reaches uncomfortably high levels, which may not happen for a few years.
All of these factors are generally bullish for stocks. But since these factors are not new, and markets have more or less priced them in. At this point, no one is worried about the overhang of newly created debt or the prospect of inflation, both of which could derail the rally.
Further social unrest could disrupt the supply side of the economy. Violent crime has spiked in a number of US cities, just as it did in the aftermath of demonstrations in Baltimore and St. Louis (homicide rates rose 23% between 2014 and 2016) partly because police pulled out of troubled neighborhoods. Now with elected local officials nationwide looking to weaken their own police forces, there could be a repeat. This is important because historically there has been a correlation between a rise in violent crime and declines in asset prices and increase in inflation. This will be something to watch out for.
The big rebound in equity markets has been on the back of highly speculative activity. One need not look much further than the 10-fold increase in the shares of Hertz after it declared bankruptcy. Or the fact that Tesla trades at a market value of $610,000 per car produced, and Volkswagen, a much more established auto manufacturer with a diversified portfolio of brands, trades at a market value of $7,200 per car produced. Or a massive uptick in call option activity among small traders (see below).
It should be noted that historically a massive increase in speculative activity such as this occurs near major highs, not major lows in stocks. As Charles Kindleberger wrote in Manias, Panics, and Crashes (1978), a highly recommended book, in a Mania "a larger and larger group of people seeks to become rich without a real understanding of the processes involved.” I see that this is the sad legacy of Fed policy – instead of its largesse going to boost real economic activity, it has turned the country into a casino.
Investors, in the face of zero to negative returns on bonds do not know what to do. They know they have to take some type of risk, so they opt for index funds despite the fact that 21% of the S&P 500 is driven by 5 super-risky, nifty fifty-like stocks (see below). But the problem with putting money into an index or index-like portfolios is that narrow leadership tends to coincide with major highs for that index and signal the beginning of a period of huge underperformance relative to other investments.
For our part, we believe our clients want to earn a fair return with little risk. Our clients have already acquired wealth and do not want to lose it. But they still want to be compensated for risk they do take. COVID changed the risk paradigm, as whole industries were looking at mass insolvencies. In hindsight it seems obvious that Fed intervention would cause a massive rebound in everything, but as everything shut down it was not clear prices of stocks of the most challenged businesses would recover. Insolvencies can still happen and there is little the Fed can do about it other than direct bailouts.
We still believe that financial analysis works and will help our clients earn high risk-adjusted returns. We try to keep the businesses in which we invest simple, predictable, dominant, with excellent management, having high barriers to entry, high free cash flow, high returns on capital, strong corporate governance and without a need for external financing to survive and thrive. We also want to own them at a fair price.