October 8, 2020 During the third quarter the markets returned to more normal results after the roller coaster that was the first and second quarters. The results were good with the S&P 500 up 8.9%, the Russell 2000 small stock index up 4.9% and the Barclays Aggregate Bond Index up 0.6%. Yes, large stocks were once again leading the pack and yes, they are still very highly valued.
Yet, we still face many hurdles first of which is the Covid 19 Virus which is active and clearly did not recede with the summer. Vaccine research continues, but there is no way to know when or how this will be resolved. Which leads us to the next hurdle. The economy has been divided into two segments by the virus, those businesses that suffer from the pandemic and those who gain or have little reaction to the pandemic. The list of suffering businesses ranges from energy firms like Exxon down to your favorite Mom & Pop diner that is hanging on by its fingernails. The stimulus programs certainly helped the economy, but every day one continues to hear of new layoffs and bankruptcies. Our labor force is down about 4 million workers from the start of the pandemic which is largely due to people who stopped looking for work in fields like hotel maid or restaurant server because their search is futile given the low occupancy in hotels and the number of restaurant closures. A consequence of not looking for work is that the government removes them from the labor force which makes the unemployment statistics look better but conceals a group of individuals who are likely to suffer years of unemployment. In a month, the election will be over relieving some of the uncertainty, but the economy will still be struggling. Not so much because of all the political rancor but due to the fact that the virus is still damaging a large swath of the economy and there is little the politicians can do.
The other side of the economy, the part with a neutral to positive reaction to the virus continues to do well but as a result it continues to be very overvalued. The FAAANM (Facebook, Apple, Amazon, Netflix and Microsoft) are the poster children of this group. There is no way to determine when and if these companies will suffer a setback, but they are an uncomfortable investment given their high valuation.
My major concern is not a stock market selloff, it is the low returns from fixed income investments. This may seem peculiar but, I think that this is more of a concern for older investors. It is a slow-moving problem versus one like a sudden equity market crash which everyone fears. This problem results from declining interest rates coupled with inflation leaving investors without enough income to support themselves and potentially causing them to prematurely invade their principal. At the last meeting of the Federal Reserve they stated that they expect to keep interest rates close to zero for the next three years. While this is great for borrowers and stimulates the economy, it puts savers in a difficult situation. As we age, we typically shift our investments toward fixed income investments as we feel a need to protect what we have. Generally, this instinct is good but there are circumstances where it can be harmful especially to older workers heading into a hoped-for long retirement.
This problem drives investors to hold more of their assets in equity securities to generate a rate of return that would allow a retirement plan to work. We will continue to discuss this situation over the coming years. So, these days we have two factors, low interest rates and inflation that drive investors toward more equity centric portfolios when their own instinct calls for more fixed income. If this environment persists over many years, it could be worse than a market crash, especially if one does not see it eroding their nest egg.