Since the very beginning of our great nation, investment markets have been free. They have been controlled by the natural disciplines of a free market where willing buyers and willing sellers agree on the price of a transaction. The buyer has somehow done a risk assessment of the investment and decided that the price adequately compensates for that risk.
In debt markets (bonds and notes), the risk is truly a credit risk, tying the borrower to a periodic interest payment over a specific time frame until the principal becomes due. In the equity markets, the risk of failure or shortcoming is built into the price of the shares. Accordingly, higher quality stocks typically sell for a higher price than speculative shares.
The bond market eventually adopted a credit rating system through which all publicly traded debt became subject to a credit analysis by a qualified rating agency like Moody’s or Standard and Poor’s. Each bond issue is given a rating such as AAA, AA, etc. In effect, this rating is done on the issuer, reflecting its ability to meet the payment demands of each issue. Logically, the highest rating, AAA, went to the most solvent borrowers, affording them the lowest interest rates. Speculative borrowers were given the lowest credit ratings and the highest interest rates to pay.
This credit discipline applied to all of our markets, allowing investors a quick and consistent financial measure by which to make investment decisions. In the municipal bond markets where states and counties borrow money, the same is true with the most solvent municipalities enjoying the highest ratings and paying the lowest interest rates on their borrowings.
The absolute highest credit belongs to the U.S. Treasury, where the ability to pay is backed by the government’s ability to tax.
This, then, is the structure of our free markets, where credit risk is quickly discernible and quickly factored into price.
As most of you know, we have long been warning of the increasing level of debt around the world and in our country. Our concerns have been reflected in your portfolio structure where bonds and stocks reflect only the highest level of credit quality.
During the recent market crash, this quality bias along with our exposure control helped preserve portfolio valuations. Most portfolios were subjected to only 1/3 or 1/4 of the market decline. No decline is ever pleasant but a minimal one can quickly be recovered.
The market decline intensified as more investors came to grips with the seriousness of the pandemic. We quickly focused on the credit issues in our economy, and parted ways with banks and insurance companies…any entity that had a portfolio of securities. As the economy came to a halt, the looming question became how long will the virus continue…and how long can tenants pay rent, homeowners pay mortgage payments, and bond issuers pay interest? This question soon became the market’s main
concern as it steepened its decline below 20,000 on the Dow. The stock market kept its eye on the credit markets as corporate bonds and municipal bonds started a freefall.
The administration’s aid package for individuals became a political football, bouncing between the President and Speaker Pelosi. Enactment was almost assured, but when?
With the debt markets in disarray, the Federal Reserve stepped into the breech and purchased corporate bond exchange traded funds (ETFs) and apparently some seemingly “bottomless” municipal bonds.
Whether the ensuing stock market rally was sparked by the passage of the Administration’s CARES Act or by the intervention in the debt market by the Federal Reserve is really not important. What is important is that we had etched out an important market low after falling 11,000 straight points on the Dow. Whether it is a low to support a corrective 4,000- to 5,000-point intermediate rally or a permanent low cannot yet be determined.
On Thursday, Fed Chairman Powell announced the establishment of a $2.3 trillion plan to buy debt through several facilities. They will buy mortgages, mortgage-backed securities, bonds, and collateralbacked obligations. Under this set-up, if the need is greater than $2.3 trillion, we can expect the Fed to
print more money to meet that need. In one “fell swoop” Chairman Powell had taken over the bond market and done away with all credit ratings and orderliness.
He has “bailed out” the high-risk low-quality investors and done nothing for the high-quality part of the market. The stock market’s response was to be expected. The lower quality “over the counter” stocks outperformed the higher quality S&P and Dow Jones averages.
What lesson can be learned from this massive intrusion by the government into our free market? Buy junk!…is the clear message here. The long-term effects of the Fed’s intervention can still be rectified with a disciplined “pay back” scheme to the government by all these borrowers. Perhaps this intervention was the only option to prevent a debt induced spiral into a deflationary depression. Only time will answer that question. In the meantime, they have added a “casino effect” to the market place where government underwrites all risk.
I’m sorry, our DNA will not allow us to play the “junk game.” Fortunately, we had previously added some gold exposure to portfolios in an attempt to hedge against some kind of government intervention, but our portfolio stance going-forward will remain somewhat neutral until we can rationalize a second move. There will be some kind of reactive change here, but our concerns over the long haul will be about the loss of a free market environment to work in. There is now another 900-pound gorilla to have to worry about in the market place: our own government.
The rules have clearly changed and we will have to divine a strategy for this new environment. Can we expect the Fed to begin buying stock as well?
We promise to keep you advised. As always, we appreciate your loyalty – be safe and healthy.