Client Note December 2020

January 12, 2021

2020, despite a massive pandemic and a severe global recession, central banks, with some fiscal assistance from governments, have managed to keep financial asset prices elevated.  Significant declines in revenues, profits and employment arguably the worst since the 1930’s alongside surging stock index price levels, have conspired to give us the most overvalued market since 1929 or 2000 (some argue “ever”).    How long can this endure?  Depends on when central banks begin to whisper about ‘normalization’.

For 2020, the SP500 gained 18.4%, the aggregate bond index gained 7.5%, and gold gained 26%.  European shares eked out a positive year while the Asian indexes fared very well.  My conservative portfolios gained mid to upper single digits while the average moderate portfolio gained a bit more than 13% on the year.   The pullback in Moderna and precious metals provided a weak end and lackluster start to the year.    The energy sector was the worst sector in the SP500, losing 28% and the tech sector fared the best gaining 48%.  Healthcare and energy are likely to be strong outperformers in 2021.  The addition of TSLA to the SP500 has increased the risk of market volatility. Past observances of new additions to the index show they generally perform worse than prior to their addition.  TSLAs outrageous market value (valued more than the 9 largest global auto makers combined; selling at 28x sales) and the 7th largest company in the index, put the index and any sector it is in at risk of increased volatility.

Gold and gold miners are at risk of starting another correction.  Recent lows at Thanksgiving are being approached.  The rally from late November to January 6 was the largest run up since gold’s consolidation began in August.  However, IF we can hold the longer-term uptrend, upside potential is significant.   Bonds too, are seeing prices under pressure as metals/lumber/agriculture/oil prices’ surge is generating calls of “Inflation!”.   It’s quite early to claim prices are going up due to renewed growth.

Asia came out of the COVID-19 lockdowns much quicker and effectively than western nations.  This re-opening (as a result of very stringent testing/tracing/ and effective lockdowns) allowed those economies to re-stock and re-open driving up demand and prices for raw commodities.   From 2015 to late 2017 base metal prices and oil were moving up quickly.  Cries of inflation were heard then as well.  Inflation never showed up (unless you count 2.1% as INFLATION).  This is due directly to US consumer spending growth, or lack thereof.

Aggregate consumer spending is significantly below trend.    Dig a little deeper and you can see many economic indicators picked up in 2015 through 2017, then rolled over during summer 2018, after the brief impact of tax reform (most of the benefits went to the top where additional money isn’t spent). Current total annual spending was $14.8trillion and growing at 4.2% for the past few years (income at almost the exact same rate).  MOST recently spending has declined the past few months while aggregate income also is declining.  Today we can see the next few months will likely show a spending gap of $1trillion.  A $1trillion gap is almost 7% of total spending and reflects the concurrent GDP output gap and an outright decline in GDP of around 4% year over year.  Looking ahead, the real problem may lie in the US inability to deal with the virus effectively.  Yesterday, an article stated that in Ohio, 50% of nursing home workers are refusing the vaccine.   Layer in low compliance with mask mandates (>70% compliance in order to be effective), and I truly wonder if an end to the virus is, in fact, in the offing.

As a consumer driven economy, the point is, while one can find prices of products higher (or packaging smaller at the same price), we spent a lot less in 2020 and will continue into 2021.  And unless personal spending increases, we should not see a difference in the economy or inflation going forward.  This may bode well for bonds.  TLT the 20-yr treasury bond elf, gained more than 15% in 2020, but has fallen a similar amount off its highs this summer.  Expectations for higher rates may have gotten ahead of itself and we could be near a low in prices.  Layer in the fact that bets against prices are near extremes may indicate the decline in bond prices is nearing an end.

In addition, or perhaps running parallel to the decline in spending is the truly massive amount of people on unemployment insurance.  In 2006, Continuing Claims for unemployment insurance hit a low of 2.35 million.  This began to increase in early 2007 and hit a high of 6.62million in June 2009, after the Great Financial Crisis. By June 2010, this fell to below 4.5million, and continued to decline into October 2018 to 1.65million. Claims remained flat until February 2020.  May 9, 2020 claims hit 24.91million.  And over the past 8 months has receded to only 5.1million.  It was only in November that our current Continuing Claims for Unemployment Insurance fell below the GFR Peak in 2010.  The number and duration of unemployment today has not been seen in the post WWII era.  Fortunately, today, we have unemployment insurance and a Federal Reserve acting to support financial markets (almost perpetually since 2009).

We should not expect any kind of normalization in the economy or improving numbers at least until employment, and thusly spending, improve rapidly.  This is completely dependent upon containing the spread of covid-19.

Due to the length and depth of the declines in spending and employment, the longer-term collateral damage will not be seen until things begin to normalize. Once all the rent and loan deferments, PPP loans, random stimulus checks, and enhanced unemployment benefits disappear we will be able to see the extent of the long -term damage.   Ironically, that knowledge will come at the same time we declare victory over this virus-recession and may be concurrent with a market decline.

In the meantime, let us hope the Fed does not mention ANYthing about tapering the current $120billion per month they are pumping into the financial markets, hoping that the Wealth Effect is more than theory.  So, while prices continue to climb, we will participate and listen intently for any signs the Fed is “confident” enough to reduce the variety of market interventions currently underway.

 

Adam Waszkowski, CFA

This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision. Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.

Client Note November 2020

December 2, 2020

The headlines are touting how November was the best month in 30 years.  It was a very strong month that also had the benefit of October closing at its low on October 30th.  The September and October lows are the bottom of the sideways range we have seen since early August.  The post-election rally has broken out above that range and we are likely to see higher highs in the near term.  I do not expect to see more than a 5% decline in the coming weeksThe SP500 gained 11% on the month, bringing it up to 12.1% year to date. The first four days of the month saw the SP500 gain 7.4% and since then has been a slow grind up. Woe unto those who were out of the markets for whatever reason in early November.

While the S&P 500 gained 11% in November, our average moderate portfolio gained 7% on the month.  Bonds (TLT) gained slightly, and gold went from 1880/oz. to 1780/oz, a decline of 5.6%.  Gold has given up 15% from its all-time high in early August through November’s close. If one looks very closely at GLD’s price movement, there are two approximately equal declines of 11% since August.  This may indicate the end of the decline.  Gold has gained more than 3.5% the past 2 days. Over 1850 should be the all-clear.  The only changes I have made in the precious metals area is to have sold gold miners in August and then buying that portion back recently. Gold has dramatically outperformed stocks over the past 2 years through August, but stocks have been catching up during gold’s respite. I remain bullish on gold and stocks.   Bonds and interest rates continue to vacillate, with prices continuing to ebb as expectations of economic growth assume a higher demand for and ability to obtain new credit.

Over the past few months, the number of individual stock holdings has waned as markets have fluctuated.   Expect to see several names added soon with our usual starting allocation.  One name that we have held for several months finally came to life in November as its vaccine was approved.  I plan to continue to hold MRNA and look to reduce it gradually into higher prices.  Its weight in portfolios has grown so much that its weight amongst other holdings is too high, which could lead to too much portfolio volatility.

On the sector level, energy has come up strongly, outpacing all other sectors the past month.  This may seem counter intuitive, given that there is a Democrat coming into the White House.  The energy sector was so undervalued/oversold/hated that it has no where to go but up.  Since the recent low October 28th, the sector had climbed some 45%(!!) through November 24th.   More recently it gave up almost 30% of the initial climb.  Ideally, another 10% decline would make for a great long-term entry.  Energy has been exceptionally strong the past month and is still substantially below where it was early this year.

Overall, we are on track for a very solid year and I am optimistic going into first quarter of 2021.  Sentiment has been and likely will remain the primary driver of asset prices near term.  Fundamentals have a long way to catch up and traditional metrics remain at ‘all time most expensive’ range.  While sentiment can carry prices further, we really need to see earnings catch up substantially in Q1 and Q2 to avoid any large “air pockets” for prices.   Sometimes prices climb much faster during the anticipation of good things (back to normal life for example) and then progress slows.  The grind in prices since the first week of November might be an indicator of such.

Adam Waszkowski, CFA

 This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision. Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.

Post Election Outlook

Client Note                                                                                                                                                      

November 4, 2020

Pre-election volatility continued in October, with the S&P500 climbing 5%, then dropping some 7% for a net change of about 2.5%.  Gold was a little less volatile and ended the month just slightly lower.  Bond prices trended down all month, with the Aggregate Bond index down less than 1%, while the long bond fell about 3.5%.  Our average moderate portfolio declined by 1.2% on the month, bringing year to date returns to approximately 8.5% for the average portfolio.

The pre-election volatility this year is similar to previous elections.  For the 3 months preceding the election, there have been two increases of about 8% and two declines of 8%.  2016 saw a steadier decline of almost 5% in the 90 days prior to election. 2012 saw a climb of 7% followed by an equal decline.  2020 is not unlike any other year from a market behavior perspective.

Most recently markets have jumped back up (stocks and gold) into the very middle of the past 3 months’ range.  Gold and gold miners also are moving and, as I type, moving up through their respective down channels.   Markets do not like uncertainty and in the immediate term, the longer the count takes the greater the risk of rapid swings in prices.

Looking ahead, the technology sector has been lagging the general market while ‘value’ and dividend paying stocks have performed better over the past week.  The price of oil had a recent bottom on October 29, and since climbed more than 10%.  The energy sector ETF bottomed the next day and has climbed a similar amount.  While not out of the woods yet, as additional stimulus and vaccine data comes out, energy has the most room to make gains as we gain vision to further economic growth in 2021.

However, the gulf between earnings and stock prices remains at historic levels.  Market value of the SP500 vs Total GDP remains higher than in 2000.   As I have stated a few times over the past several months, I still do expect 10-20% swings in stock prices, as we have seen over the past 2 years.  As such, buying relatively ‘low’, after a decline and locking in gains after run-ups is the prescription for continued portfolio growth.

The Federal Reserve has stated quite clearly that its own monetary stimulus is needing the complimentary fiscal stimulus that can only come from Congress.  Given the current state of the Senate, any stimulus is not likely until after the New Year.  The timing of further fiscal stimulus and a widely available vaccine appear to both be pointing to a late first quarter, perhaps mid-year 2021-time frame.  At that time we should be able then to make progress filling in the substantial (greater than 2008 recession) GDP output gap and have better vision as to the rate at which corporate earnings can exceed the 2019 high water mark.

Adam Waszkowski, CFA

 This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision. Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com

Client Note September 2020

Client Note                                                                                                                                                      

October 8, 2020

September saw the S&P500 slip approximately 3.8%, ending a streak of 5 positive months in a row.  While equity markets and precious metals (oddly) are moving together, our cash and bond holdings kept average portfolio declines to approximately 1.5% on the month. Year to date through September 30, the S&P 500 is up 5.6%, while our average Moderate Portfolio is up almost 10% year to date.  The fact that financial markets are up this year, despite 2020 being on track for the worst GDP contraction since 1946, is remarkable.

Estimates for 2020 GDP growth will come in around -4%, while the 2007/2008 era saw only a 2.7% contraction.  But this time markets are faring far better.  The key difference between today and 2008 is the emergency actions of the Fed.  The Fed acted far faster and far more substantially than it did in 2008.  The labor market bottomed out in February 2010 with total losses of 8.8 million jobs.  Not until May 2014 did the US recover all the jobs lost.  Currently, we have recovered half of the 22 million jobs lost.  IF, the now-slowing recovery is similar to post 2008, it could be 5 years before all jobs are recovered.  Fortunately, the S&P500 mirrors the Fed’s balance sheet growth more than the economic data.   

History shows us that markets recover more quickly than jobs or the economy.  As such, it appears equity markets have priced in a full profit recovery in the coming year.   In 2008, corporate profits bottomed almost the same time markets did.   Profits and markets grew alongside each other for several years. This time, markets have already recovered and are waiting on profits to back fill the massive valuation gap that now exists.  Because of this mis-match in timing, we could see a few more bouts of 20% gains and declines, as data/news shows economic activity slowing or increasing; as governments decide to add fiscal support or skip it; and as hot spots of the Covid virus spike and recede over the next year or longer.

Some analysts see rising inflation and higher rates coming because of economic growth.  In order to create the ‘good’ inflation (demand-pull), consumers need to spend.  They spend wages, new credit (loans/credit cards) and transfer payments (social security/welfare/stimulus checks).  Banks’ lending standards are increasing; lending is decreasing.  Aggregate wages have declined each month since May. Finally, in August the Cares Act $600/week stimulus ran out while 10 million remain unemployed, keeping pressure on consumer spending.  The Chairman of the Federal Reserve has asked Congress for fiscal stimulus to lift the economy.  As it stands now, there is no real impetus for market rates to rise, and may bode well for bond prices, as rates stay low or perhaps decline again.

My outlook for markets and rates remains the same as during the Summer.  Rates remain low and there is a good likelihood of large swings in market prices.  That outlook will remain until either a large stimulus package with money going right to consumers or control of the spread of the virus occur, maybe both.  I am expecting a post-election rally that may start mid to late October, simply because regardless of the winner, markets like certainty.  Precious metals appear to have completed their correction and a nascent rally may have started.

Adam Waszkowski, CFA

 This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision. Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.

Client Note August 2020

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

 This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision. Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.

Client Note July 2020

After a brief pause in June, financial markets continued their climb, trying to get to even on the year.  Of the major indexes, only the tech-heavy NASDAQ has managed to make new all-time highs.  The discrepancy across indexes is significant.

Off its all-time high             year to date price return

The Dow:                              -10% (Feb 2020)                                  -7%

S&P 500                                 -4% (Feb 2020)                                 +1%

Russell 2000 (small cap)    -12%   (Jan 2020)                               -10%

NASDAQ                                  -3% (July 2020)                                 +20%

EAFE (Eur/Afr/Far East)      -15%  (Jan 2018)                                 -8%

 

Inside the NASDAQ, the top “6” holdings are Apple, Microsoft, Amazon, Facebook, Alphabet A shares and Alphabet B shares.  These 5 stocks make up 44% of the index.  What this means is that only a handful of stocks, in one sector, are keeping the overall indexes up.  One can say, “so goes tech, so goes the markets”.    US mega cap growth/tech has been the only game in town.   More recently tech has weakened against the rest of the market.   If tech loses it dominance without another sector or two to take the reins, equity markets will have a bumpy second half 2020.

Portfolios I manage continue to do very well.  Gold is in the news a lot recently.  Over the past 15 months, gold has dramatically outperformed equity markets, and climbed 65% since November 2018.  The last 15% of that has come in the past two weeks.  Trimming and taking profits is on the schedule for August.   The individual stocks I choose from time to time have become a mixed bag.  IRBT and APRN recently reported significant upside earnings surprises, only to be sold off hard.  I am seeing this in several areasIts feeling like a ‘sell the news’ kind of market.  After a 50% climb since the March lows, its not inconceivable that stocks will take a breather.  Perhaps even give back some as we adapt to living with Covid19.     Clients can probably observe the steps I have taken to reduce exposure and take some profits, so that if/when we get a correction, it should not be too painful.

July 30, 2020 has the potential to be a historic day.   GDP for the second quarter 2020, covering March 30 through June 30 will be released.  Current estimates are to see a contraction in US GDP of -30%.  This would be the worst quarter since Dec 1946 and sets up the worst year since then as well.  While this is widely known to people who follow it, I am sure it will be a shock to some, and widely covered in the financial press.   In addition, all the tech stocks mentioned above will report earnings.  They will all be very profitable, but if this is indeed a ‘sell the news’ market, beware.  Microsoft already reported on July 22, beating estimates, and was sold off by 6%, recovering only a part of that decline this past week.

The economy is not coming back as fast as hoped and is already showing signs of levelling off.  Roughly 10% of our economy has disappeared (hospitality/tourism).   As long as the Fed promises, and CONTINUES to inflate the monetary base, financial markets can remain elevated However, if a small correction gets out of hand, the Fed has little influence in the very short term—and not much new to offer.  .  The real economy however will not come back without greater spending from consumers and businesses—either through earned wages, or stimulus, or loans/credit.

 

Adam Waszkowski, CFA

Client Note June 2020

As we close June and the first half of 2020, financial markets continue their rebound from the first quarter’s corona-crash.  In very volatile markets there will be many “best/worst X since Y”.  The close at 3100 on the SP500 reflects the best quarter in the sp500 since 1987, with a gain of 19.9%.  After a 36% decline off the all-time high and subsequent 40% gain, puts the SP500 at -4% year to date and -9% below the all-time highs.  Our average moderate portfolio gained almost 15% for the quarter and is up 4% on the year.  While further upside is possible but in the short term, US equity markets are in a downtrend since June 23.  On a larger time, frame, we have downtrends since June 8 and off the highs on February 19thGetting over 3200 should open the door towards 3400+, but if we lose the 3000 level, my medium-term outlook will change.  Our individual stocks continue to do very well.

International equities continue to sorely lag US equities.  European shares gained 2.5% on the month, and currently sit at -14% year to date.  Japan gained 1% and China ebbed 1.6% on the month and both fall well short of the SP500 at -7% and -9%, respectively, year to date.  Emerging markets were the winner on the month at +6% but also have made far less progress recovering post-crash, coming in at     -11% year to date. We sold the last bits of emerging and international equities towards the end of the month.

In credit markets, treasuries have dominated over all other areas of the bond markets.  The long bond/20-yr treasury ebbed by 2.25% during the month, is flat for the quarter and up a massive 20% for 2020.  Even with equivalent maturities, treasuries are outpacing investment grade and junk bonds by 5% and 17%(!) respectively.  The investment grade corporate bond etf, LQD is up 5.1% ytd, while junk bond etf, JNK is -7.7% ytd.   This disparity is due to the rapid credit deterioration seen during this severe recession.  Given this, and spike in covid19 cases, its unlikely rates will rise appreciably in the near term.  Our long treasury position was reduced late March at slightly higher prices.

Economic data released in June continue to show improvement over the April/May shutdown (naturally).    The pace at which the economy would rebound after reopening is a hot topic.  We are seeing rapid improvement in some areas but the estimates versus data are showing extremely poor forecasting ability by economists in the short term.  I am watching year over year data to see how much rebound we are getting.  If July and August data show similar growth as May and June, we could see 90% of more of the economy back by Labor Day.  The trend of economic recovery is far more important than the level.  Ideally, we will trend higher and higher until full recovery.   At the end of July, we will get the first read on GDP for the second quarter.  The Atlanta Fed current estimate has risen to   -36%. 

Looking forward, the recent spike in virus cases has opened the door to the risk that the re-opening of the economy will be slowed, as we are more likely to see county or regional shutdowns.  Continued support from the Fed and continuation of stimulus programs are critical.  A bit higher in equities may provide some momentum to get to 3400 and Fed intervention can keep rates low.

Adam Waszkowski, CFA

Client Note May 2020

June 1, 2020

Like April, equity markets started the month of May off slowly, but over the past 10 days, the S&P500 has gained roughly 4.5% on the month putting it at -5.7% year to date.    International equity indices gained a bit more for the month but continue to lag the U.S. by a wide margin.     Bonds were generally flat, with junk bonds moving up alongside stocks, while a small move up in interest rates pushed the long bond (TLT) down slightly on the month.   Gold moved up almost 3% on the month, after being up almost 4% mid-month.  And our individual stocks continue to do well, enabling our average moderate portfolio to add just over 3.5% for May and for year to date returns approaching 4%.

Looking ahead, it appears investors are pricing the market in expectation of a solid second half recovery and near full economic recovery into 2021.  While investors have bid up prices in anticipation, there is a loooong way to go to recover from the sinkhole we are in.   Current earnings estimates for second quarter are expected to drop 35%, reflecting a full year estimate of around $100/share of the SP500. If that occurs and the expected earnings bounce in Q3 and Q4, we have a forward Price to Earnings ratio of 30x, which is extremely expensive.  We will see earnings in mid-July; first read on GDP at the end of July; and all the while we will see employment numbers each week.   On going jobless claims have now exceeded 20 million, reflecting an unemployment rate a bit under 15%.   Economic data will remain dire.  The hope is that employment and spending figures rebound rapidly in the coming weeks. 

As mentioned last month, the expectations and sentiment that direct short term prices are well ahead of actual improvements in employment or spending (declining).  We have made significant progress in flattening the curve with the virus.  We have seen stock prices climb dramatically alongside the hope of a rapid economic recovery. However, we are seeing an even more stretched disparity between current prices and reality on the ground.  This does keep markets at risk of wide price vacillations.

Attaining and holding 3000 on the SP500 does allow for further upside in the markets and while I rotate out of individual stocks that have lost their ‘mojo’ (or take profits), there is another handful I am tracking and may show up in portfolios in the coming days.  In my April Observations and Outlook, with tongue firmly in cheek, I outlined a path for stocks to 4000 if the Fed continues to add liquidity/monetize debt. Since that writing, the Fed has covered a quarter of that quantity.  The rise in the Fed balance sheet has paralleled a rise in equity prices. The Fed continues to plan for and express willingness to continue its balance sheet expansion in pursuit of its stated mandates: full employment and stable prices.

Prices across virtually all asset classes remain constructive considering Fed actions and optimism towards renewed economic vigor.  State re-openings have occurred, and the expectations are for rapid improvement in employment and spending.  There is a nascent uptick in the outperformance of equal-weighted and value indexes versus the general market.  This market characteristic often shows up at the beginning of economic expansions and longer bull markets.  June’s economic data and market price action should give us a great deal of insight into the remainder of the year.

Adam Waszkowski, CFA

Client Note April 2020

Equity markets moved up strongly in April.  The S&P500 moved up 12%, and currently off 3% from the April 29th intraday high.  Gold jumped early in the month, then flat for a gain of 7% in April.  Long treasury bonds moved up in price by 1% but have been on the wane since April 21st.   Most asset classes have been rangebound (+/-3%) since early to mid-April, reflecting a decrease in market momentum.  The average moderate portfolio gained approximately 9% vs the SP500 gains of 12% in April.  Year to date, through April 30, SP500 is off 9.9% while most portfolios are very close to 0% year to date. 

Economic data continues to come in at extremely negative levels.  Auto sales fell by 45% April 2020 vs April 2019.  China, in February saw a 90% drop.  Current market sentiment is bearish and consumer confidence declined from 101 in February to 71 in April.  This is similar to the decline from February 2007 to June 2008 (the month Fannie and Freddie’s first attempted bailout, after losing 50% of their value that month), which saw a decline of 35%.  This could be another reflection on how this recession is being ‘front-loaded’.   We have seen already how GDP and employment has fallen as much as the entire 2008 Great Financial Crisis, but now expect robust rebound by year end.

In light of all this, equity markets have remained buoyant, after the March decline.  This may further indicate the front-loaded- ‘ness’ of this economic period.  And at the root of it all is the expectation that the economy will rebound strongly in the second half and especially in the 4th quarter of 2020.  While GDP estimates for Q2, which will come out at the end of July, range from -10% to -30% (annualized basis), some estimates for Q4 are as high as +20%.    I believe that we are again priced for perfection.  The past few years saw valuations (price to earnings, price to sales, etc.) elevated with expectations of an acceleration in earnings and wages to justify the then-current prices.  Today a significant economic rebound is priced into the market.   If the economy in late May and June isn’t picking up quickly enough it could put pressure on equity prices.  It depends on re-opening the economy and that depends on subduing the pandemic.

We have seen momentum decline recently and thus increases the potential for volatility in equity markets.  If the S&P500 cannot breakout above 3000 in the near term, we’re likely to remain rangebound vacillating +/- 6%.  Bonds and gold are at a point where they are testing support and have the potential to move several percent as well.  If we are to remain rangebound, my preference would be to reduce risk until there is more confidence in further upside.

On a side note, I have significantly reduced the amount of cable and national news I watch on TV.  It’s the same sad and fearful story we’ve heard the past 6 weeks.  I have noticed I feel better doing this.  A client went back north recently and was surprised/disheartened at the difference in the local news in Naples vs the local news in the tri-state area.  Avoiding the bad news TV and enjoying the good news of spending time with family/projects/hobbies/exercise can be an important factor in getting through this time and being ready to embrace the other side of this crisis.

Stay safe and thank you,

Adam Waszkowski, CFA

Observations and Outlook April 2020

Current State of the Markets

After the most precipitous fall in market history and now a 50% bounce-back, investors are trying to figure which way the wind blows.   The NFIB (Natl Federation of Independent Businesses) estimates that half of all small businesses cannot survive the shutdown through June.  Small businesses make up half of all employment.   We are already seeing massively negative numbers in unemployment claims and PMI surveys.  This is expected given our current situation.   IF unemployment is going to 25%, has the market priced this in already, albeit briefly?  Will the several trillion dollars in stimulus and liquidity overpower economic gravity and keep asset prices elevated?  Valuations for stocks had been in the top 2% most expensive of all time, for a couple of years.  If prices stay or climb higher without commensurate wage/economic activity, valuations could surpass recent levels—inflation in assets, deflation in wages.  In the past, these two generally have not gone together, except in the post 2008 era.

In addition, past recessions have seen job losses increase over several periods.  This time, a lot of the economic impact is happening in a short period of time.  Much of the impact is being front-loaded AND is expected to be short-lived.  Estimates are that GDP has contracted as much as all the previous recession.  As we contract further, the risk that we have not done enough stimulus becomes greater, extending the timeframe for recovery which in turn will lower sentiment and expectations for asset prices.

Which is it? Bull or Bear Market?

The terms bull and bear have a long history, dating back to the 18th century during the South Seas Bubble.   Some attribute the attacking postures each animal takes, the bull goring and lifting upward; the bear, swiping its claws downward.  The definitions we use today though are very new, dating only to the 1970’s.  The arbitrary 20% measurement to label a market as a bull market or bear market can be misleading.   We say today that the recent fall was greater than 20%, thus a ‘bear’ market; and now we have seen prices rise more than 20% from the bottom, a ‘bull’ market.  Do these labels help us in determining whether to be invested in stock markets? Do these labels provide any clarity to the nature or outlook for the markets? No, on both questions.   For a far longer time the terms bearish and bullish have been used to describe the nature of the market.  Bear-ish and bull-ish can better describe the character of the market one is in.  A trend can be described with these terms, also the behavior can be better characterized with these terms.  In bearish markets, large daily movements can be seen in the context of a downtrend.  Bearish markets move fast.  Bullish markets are a slower daily grind in an uptrend with a rare day showing more than 1% or 2% move.   Its certainly a subjective interpretation, but the change from a bearish market to a bullish market, in addition to a visible trend change, should also see smaller intraday percentage moves.   While the daily trend has turned up, the daily percentage moves remain elevated.

A Visual of Fed Interventions

Recently, some famous names from the 2008 crash reflected on that period and concluded they should have acted faster and with larger amounts of stimulus.   The Fed certainly has taken that to heart this time around and indeed has acted with vigor.  The first chart below tracks the Fed’s actions overlaid with the S&P500.  Even after the bottom, the Fed continued with QE 1, 2, Operation Twist, and QE 3.

fed actions vs sp500 2008

All the Fed actions, in real time, did nothing to stem the decline in prices.  The S&P 500 Price to Earnings ratio in early 2009 exceeded 100 (trailing 12 months earnings).  In late 2008, we saw 50+, prior to banks recognition of their losses.  Here is another chart, with recent Fed actions overlaid against the S&P 500.

fed actions vs sp500 2020 resized

Looking at these, an honest question is whether the Fed has any influence over equity markets in the short term.

Covid-19 or Global Dollar Funding Issues?

Few remember way back in September 2019 when the US overnight interbank lending rate increased by a factor of 5, rising from the targeted 2.2% to almost 10% (annual rate, intraday) on September 16th.  This caused the Fed to intervene, putting $53billion into interbank lending on an overnight basis.  The overnight lending quickly morphed into multi-day and multi-week repurchases agreements totaling more than $300B in a few weeks.  Previously banks had been lending to each other, overnight, secured with collateral (red line).  The Fed went from no participation in the $1 trillion+ overnight market to more than $350 billion, and then moved from repurchase agreement to outright permanent purchases and began the massive balance sheet expansion we are seeing today.  The Fed balance sheet rose from $3.76T in mid-September 2019, to $4.3 by March 11, and now is $6.4 trillion. Another $1 trillion and the recent expansion will be larger than QE 1, 2 and 3 combined.

The red line secured overnight lending began spring 2018, right after the February 2018 market correction, AND foreign dollar-funding costs (TED spread- orange line) jumped to the highest level since 2009.  The volume of funding increased for several months until banks ran short on capital to use as security, as dictated by liquidity rules in the Volcker Rule.   While demand (red line) had been growing for liquid cash dollars, the amount of collateral used to secure this lending was not enough, and when demand outpaces supply, the price (overnight funding rate—green line) goes up.  But that price was too high, and the Fed intervened, and the total volume of dollar funding continued to increase (red and blue lines together) at an increasing rate.

repos global dollar

We can see how due to the demand for US dollars began to increase in early 2018 (orange line), funding for dollars increased to a point where major banks could not meet demand for dollar liquidity, and the Fed stepped in and took over funding.  There was balance in the supply and demand from November 2019 to the end of February 2020.  From February 26 to March 4, the TED spread (a measure of stress in markets) began to grow rapidly.  The economic contraction stemming from Covid-19 exacerbated the serious issue of dollar funding (less activity means less trade/less dollar flow).  Today the Fed is fighting the dollar crisis AND the loss of over $2trillion in US output/GDP.

Monetary Base and the case for S&P 500 to 4000

For most of the post WW2 era, the growth of the monetary base (all currency and bank reserves) tracked the growth in GDP.  Historically, growth in GDP lined up very well to growth in the S&P 500 over a full business cycle.  During the Great Financial Crisis (GFC) with hundreds of billions of mortgage loans going bad, there was a risk that if all the loans were marked to their true worth that the monetary base would contract, resulting in a deflationary debt spiral.  In our current system all money is created by new credit.  If too many loans go bad, the monetary base declines as money that was lent/created disappears as collateral prices decline, and loans are not paid back.

The solution was for the Fed, for the first time in its history to accept as collateral (and purchase outright) mortgage-backed securities.  As the Fed accepted these securities, it provided cash to banks. Without the burden of non- or poor- performing loan, banks were freed up to lend again.  As this new cash was put into the system it also flowed into risk assets like the stock market.

The chart below clearly shows the relationship between QE and the S&P 500.  New cash found its way into stocks and pushed prices up.  The period after QE3 and the brief ‘balance sheet normalization’ saw the most significant corrections post GFC.  A minor 15% correction after the base stopped expanding in early 2016 followed by a 19% decline late 2018 and now the 30% decline most recently.  Other banks, namely China did keep expanding their monetary base in late 2015 and into 2016.  Then as China’s credit impulse wore off and as mentioned earlier, demand for US dollars kept increasing while the Fed lowered supply, we had the late 2018 market sell off.  The Fed backed off its plan to raise interest rates and cut rates summer 2019.  These actions aided liquidity and stock moved up after both actions.

With each QE period we saw the monetary base and the S&P 500 market capitalization increase.

Change in S&P 500             Change Monetary Base

QE 1              +37%                   +33%                                                                                   QE 2              +12%                  +33%                                                                           QE3/Twist    +53%                  +52%                                                                               2019 Cuts    +34%                 -20%  needed rate cuts were due to MB decline  2020             -15%                       +43%

monetary base

Currently the Fed is trying to increase the monetary base to keep asset prices and liquidity up.  We do not know yet to what degree the current recession will lead to loan losses and other credit destruction.  In addition to loans going south there is the general decline in output as we are locked down.

Through April 8th, the Fed has increased the monetary base by $1.2T, or 35% over late 2019 levels.  $1.2T may be the approximate output lost during the lockdown.  The Fed has expanded its collateral and purchases from treasuries and mortgage backed securities to now include junk bonds, corporate bonds, and other collateralized loans.   Over the past week and going forward the Fed will likely continue to monetize these securities, further expanding the monetary base.  If we see another $2T to the monetary base (Fed balance sheet expansion) that would approximate a 100% change in the MB and potentially impact the S&P500 similarly, going from 2100 in late March to 4000 by end of the year.   In this scenario, one would have to accept a reality of 12% unemployment concurrent with S&P500 at 3500+, and a $2 trillion annual deficit.  The wealth disparity would be substantially more extreme than in recent past.

We are entering a period in US history like no other.  The reaction to the Covid19 virus has put the economy into a self-induced coma.   Current expectations are that monetary and fiscal stimulus will pave over/fill in lost income and liquidity setting the stage for a return to economic growth.  The problem with this thesis is that we do not know how long the shutdown will last and after many small businesses run out of cash and close, how many people will get hired back.   There is substantial risk of extremely poor economic data to persist for several months.   The knock-on effects of a prolonged shutdown are difficult to estimate.  The more unknowns, the longer the shutdown, the worse the global dollar shortage, the more extreme market movements we are likely to see.

 

Adam Waszkowski, CFA