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Core Comments Quarterly Newsletter

July 10, 2020 The S&P500 recovered 20.5% leaving it down 3.1% for the year. The speed of the decline was rivaled by the speed of the recovery that took place during outright economic carnage. The stock market was looking past the pandemic and the declining economic activity in many cases in an irrational manner. Some say this was driven by the closing of casinos and professional sports which eliminated an outlet for speculation.

Small investors became large buyers of speculative options contracts as well as zombie companies like Hertz which saw their share price double after filing bankruptcy. Hertz even considered a new stock offering while in bankruptcy which they canceled after some pointed questions from the SEC. This speculative fever occurred in an environment where a V shaped recovery was thought reasonable especially by politicians, the Federal Reserve stabilized the bond markets by buying in nearly every market that was in distress and for the first time they purchased junk grade debt. Then the Congress enacted a $2 trillion stimulus package that supports both businesses and individuals including lending, additional unemployment benefits and free money in the form of the Stimulus Check and the PPP loan.

I do not think most people realize how severe the damage has been. During the Great Recession of 2008/2009 there were 37 million claims for unemployment benefits over 15 months. By May 28, 2020 roughly three months into the pandemic claims totaled 40 million and they have been growing at something over 1.5 million per week. Yes, this was also the fastest loss of jobs in modern times. The latest unemployment number 13.3% does not seem so bad, but the figure calls some furloughed employees employed despite not working and not being paid. There is also the issue of those who are not looking for work which means they are removed from our labor force and not counted as unemployed, because the businesses they work for are closed like hotels and restaurants. When one accounts for these issues the unemployment rate is closer to 20%.

The Price Earnings ratio for the S&P 500 was 13.4x on March 31 moved up to 21.7x on June 30. This rapid expansion occurred during a collapse in business margins and earnings slow down. This is not the type of economy that should support rising stock prices. When we look at the value stocks, we see deep losses year to date. So, that leaves the growth stocks to account for the recovery but when one looks closely the recovery is largely confined to six companies that go by the acronym FAAANM (Facebook, Apple, Amazon, Alphabet, Netflix and Microsoft). This story starts on January 1, 2015 when these six stocks start to outstrip the share price growth and the earnings growth of the 494 other companies in the S&P 500. By May 18, 2020, they grew 325% while the S&P 500 ex. the FAAANM grew 10% over that 5 plus year period. The stock market measured by the other 494 companies did not really recover. The FAAANM ran away from everyone else making this market very concentrated in a few names and selling at a composite PE ratio of 40x.

While the various government programs have stabilized the economy, things will not go back to the good old days until we have the Virus really under control. Half of the decline in spending has come from households in the top 20% of income. They have the money but are not prepared to risk their lives by going back to their pre Covid lifestyle. Only when there is an effective vaccine will people voluntarily consume from travel, food and beverage and any other business that requires close personal contact like working in a high rise or needing public transportation. It is important to have reasonable expectations about when and if a vaccine will arrive for general use. The truth is we do not know but 30 to 40 well-funded entities are working on the problem because it will be very lucrative for the one who finds the solution. In the interim the economy will not regain its former vigor and we will live in an economy operating well below its capacity and needing government support to deal with the problems of chronic unemployment in those sectors where close personal interaction is the norm.

Continuing government intervention will likely be required to support the economy. Investors should be wary of this situation as the market has separated itself from the economic reality and could react negatively if it appears that the government is withdrawing its support. A more defensive posture is reasonable while we deal with the uncertainty of the virus and the upcoming November elections. Focusing on fixed income and defensive equity investments like Value stocks as well as developed and Emerging foreign markets will reduce exposure to the highly valued sectors.

Since the crisis, the Federal Reserve has stabilized various bond markets in which they directly intervened. The impact of the intervention spread positively to other markets like commercial real estate mortgages and corporate bank loans. The investment grade bond market measured by the Aggregate index rose 3.0% in the second quarter and is up 6.3% for the year. Basically, the bond market came to believe that the Fed would do what was necessary to keep the market functioning. While this year’s gain has been impressive, future gains will be restrained by today’s low yield unless the Fed takes interest rates into negative territory. In the recent past each of the governors of the Federal Reserve including the chairman have stated that negative rates are not on the table.

So, while technology stocks were the main beneficiary of the recovery rally that left the bulk of the market much more reasonably valued. Many of these stocks provide good dividend streams which will compare well against the return on high quality bonds once the crisis resolves itself. The early reports say many foreign countries have handled the containment of the virus better than us and could be a good place to invest. These securities also trailed the FAAANM over the last five years.

Basically, I expect that diversification will work once again as it becomes clear that the FAAANM does not replace everything. If you recall the phrase “The internet replaces everything!” from the late 90s, then you know that it did not work out that way. There are some difficult days ahead, but the growth of the world economy will resume.

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