September 3, 2020

August saw the S&P500 gain approximately 7% on the month, making 5 positive months in a row; and the last 9 of 10 days have closed.  Over the past few hours today, September 3, the S&P 500 has fallen 3.5%.

While the equity markets pressed on in their upward trajectory, gold fell just over 1% and long dated bonds saw a decline of just over 5%, while the broader bond market fell less than 1%.  Combine the various asset classes and our average moderate portfolio for August was flat to slightly up on the month.

Looking ahead, valuation on the market have become extreme-ier than normal as analysts forecast full earnings recovery plus some.   The Forward P/E ratio, the price you pay per $1 of earnings is just under 23x.   This compares to 19x in January 2018; 26x in 2000; and a mild 15x in 2007.   The economic recovery has been V-shaped.  The most recent high-frequency economic data coming in is showing a reduction in the pace of growth coming out of the second quarter.  That is, the right side of the “V” is getting rounded off and is lower than before the pandemic shut down.  This general lower level of economic activity will likely persist well into 2021 as localized covid-19 outbreaks and continued travel restrictions prevent the hardest hit areas from recovery.  Fuel usage by airlines is off by 55%, July 2020 compared to July 2019.

Gold and bonds have been in an extended sideways consolidation going back and forth in about a 6-7% range since mid-June. Staying over $1900/oz is critical.  Rates/bond prices are likely to remain range bound but may see a test of recent highs (approx. +4-5%).  Today’s stock selloff may mark the beginning of the pre-election volatility.  And if we see a total 7-10% correction should give us the opportunity to look at more individual names again, using the large cash position that we have.  Either way the election goes, once settled, should be constructive, as the market dislikes uncertainty.

Fortunately(?), the S&P500 has a very tight relationship to the Fed’s balance sheet which went from $800billion in 2007 to $2.2trillion end of 2008.  The Fed’s balance sheet continues to rise to $4.5trillion by end of 2014, after which was a gradual decline to a low of $3.7trillion in August of 2019, just before the recent dollar funding crisis in September 2019.  Over the past year, the balance sheet grew from $3.7trillion to   $7trillion recently.  The Fed added $3.7trillion over 6 years to get prices back up after the Great Financial Crisis; and now has added again, $3.3trillion, most over the past 6 months, to keep asset prices high.  I see no reason why the Fed or other central banks would choose to even hint at reducing support for markets.

The need for central banks to continue to “add liquidity/support” to financial markets is, at its core due to lack of savings, which flows from income (for individuals) or profits (from corporations).  Without natural savings from the economy, new money must come from central bank “balance sheet expansion”.   Which dovetails into the idea that low rates beget low growth.  An extended period of exceptionally low (even negative) rates has resulted at best, in below average economic growth.  Longer term, rising aggregate income from higher interest rates (someday) and increase in aggregate incomes should support longer term growth and healthy stock prices.  In the medium term we need to be aware of and take advantage of, larger swings (up and down) in the markets until that takes hold again.

Adam Waszkowski, CFA

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