The onset of the global pandemic has brought varied responses from leaders around the world, but in each and every case, the result has been a clear-cut negative for the world’s economy. For an economy leveraged by $270 trillion of debt, economic health and growth is an imperative. Conversely, a downturn will most certainly bring debt default and further economic weakness…a downward spiral of events that can only end when and if growth returns.
We, in the United States, are a significant piece of this global puzzle and it is no wonder why the media are focused on what kind of a recovery we are going to have, and how that recovery will manifest itself in the investment markets. The Wall Street crowd is looking for a logical linkage between the economy and markets and gradually, they are coming to the conclusion that the stock market is well “ahead” of the economy and might be overpriced. Actually, the Standard and Poor’s 500 (S&P) is trading at about 26X existing earnings, well above its normal 16X multiple.
Should corporate earnings fall short of expectation, stocks will be even pricier. It has become obvious that the money flowing into the stock market is not chasing value in the conventional sense. The tone is clearly more speculative and the main targets are technology and biotech companies which can grow in spite of and because of the pandemic. The risk in the stock market is rising and we are keeping a close vigil over your stock investments.
The bond markets have been even more chaotic as debt levels increase as the economic numbers decline. By mid-April, there were few, if any, buyers for junk bonds, corporate bonds, exchange traded funds, and municipal bonds of questionable states and cities. Motivated sellers were taking large “haircuts” to effect sales transactions. The capital markets were in “lock up” mode when Federal Reserve Chairman Powell stepped up to buy $1.3 trillion worth o flocked up corporate and municipal debt. This action precipitated a powerful stock market rally while providing the needed liquidity to our capital markets.
Powell’s actions were unprecedented, but they sent a powerful signal to investors. The Fed Chairman would stop at nothing to prevent a market collapse. Unfortunately, investors also got another message – that high risk, low-quality debt would be virtually guaranteed by the Federal Reserve in the event of default. In essence, there is no difference between a B rated corporate bond and a AAA-rated Treasury. By virtue of one transaction, Chairman Powell had rewarded high-risk investment strategies in “junk” paper while ignoring investors who stuck with the highest quality paper and bonds. His actions destroyed the credit rating and risk assessment discipline for all investors, including banks and insurance companies. While he “de-risked” a perilous moment in the credit markets, he also guaranteed all ratings of debt for an army of investors seeking a competitive rate of return. This buying has kept interest rates very low, affording retired savers in need of investment income no relief.
Powell’s game of picking winners and losers has extended to the financial institutions as well. Bankers normally have the discretion to lend money and manage their balance sheets, but Powell’s newly-printed money will flow through syndicates managed by the BlackRock’s and KKR’s of the investment side of Wall Street. Banks, instead, are limited in lending out deposits which effectively curtails the new money multiplying throughout our banking system. Our banks are sitting on excess reserves of over $3 trillion. Under normal circumstances, we could expect these reserves to multiply by up to 17X as banks lend out the same dollar over and over instead of parking it as is now the case. In addition to halting the lending of excess reserves, the Fed has disallowed banks from increasing dividends or using their balance sheet assets to make acquisitions. The unintended consequences of Powell’s intervention are likely to cause a mis-allocation of capital and a distortion of risks and returns in our capital markets.
Real Estate as an asset class has also gone through the “wringer” because of COVID-19. Many renters and mortgagees have found themselves unemployed and unable to make future payments. Many commercial lessees ranging from hotels to stores and restaurants are deferring payments to landlords. Besides the coronavirus effect, recent street riots have destroyed properties…how about some commercial property in downtown Seattle, New York or Washington D.C.?
When one takes the time to analyze the pros and cons of the various asset classes, it’s easy to see the benefits of owning stock in good public companies. Typically, corporate dividends give one a higher yield than interest payments from bonds…even the junk ones! Additionally, dividends are taxed at a lower rate than bond interest. Lastly, good quality stock investments are very liquid.
Our conclusion is that money is flowing into the stock market because it is the “only game in town.” Accordingly, stock market behavior has little or no linkage to valuation fundamentals. This phenomenon could continue for a while, or stop as soon as some event “pops” the speculative mood. That event could be a runaway coronavirus or an overwhelming election outlook that indicates a probable change in policy to higher taxes and more regulation. Either would signal a severe market correction.
In that event, precious metals like gold and silver could be an effective hedge against the long-term erosion of the dollar. The undermining factors for our currency begin with the nearly $10 trillion of spending and borrowing that has already occurred this year. This increment of spending will be added to an already accrued $21 trillion in prior spending to reach a seemingly insurmountable deficit level in excess of $130 trillion. When one considers that the deficit has quadrupled since President Bush left the White House nearly 12 years ago, it raises questions about how long the dollar can continue as the world’s reserve currency.
The demonstrations and riots in our cities, showcasing the destruction of private property and public monuments and statues does not reinforce the kind of confidence needed for a strong and stable currency.
The polarization within our society sets up the coming election as one of the most critical in our country’s history. The clear move to the left for the Democratic Party brings with it a strong hint of socialism, while the day-to-day antics of President Trump, along with the negative views of many ex-administrative officials paints a picture of inconsistency or perhaps even incompetence in the White House. Neither party seems to represent the right solution for our problems.
Our purpose for sharing these views and opinions is to share the thinking that influences your portfolio structure. Often, a simple “buy” or “sell” in your portfolio can best be explained in the context of the big picture as we see it.
Presently, portfolios are moderately exposed to common stocks, with a hedge against a weaker currency represented by mining stocks as well as gold and silver directly. Likewise, a small but sufficient exposure (6%-7%) in longer term Treasuries would help to hedge against a deflationary depression. The largest single exposure is in short term Treasuries and cash, which should be effective in a declining market. We know our investment process works and we continue to be dedicated to wrestling with these issues on your behalf. This year, we are roughly “flat” in returns compared to a market that is down about 4,000+ points (Dow Jones Industrial Average) …so far so good. Moreover, for 40+ years we have dealt with these kinds of issues and are still able to claim a rate of return near 9% per year over those 40 years. Obviously, we are not about to abandon our way of investing.
We also confess to having a positive bias about our country. Unless we decide to change, we remain the bastion of freedom, liberty and innovation. Just look around and witness the new growth stocks: Amazon, Google, Tesla, Microsoft, Nike, Amgen, Apple and many others. I often reflect on the list of leaders when I entered this business: Polaroid, Eastern Kodak, Zenith, RCA, Univac and yes, GE and IBM; most of which have since disappeared. This kind of creative destruction is the hallmark of capitalism and can only take place in a free and innovative society. It represents true progress.