What times we are in…between a truly historic, global pandemic threat and a similarly ugly political climate—and their impact on our daily lives—one can be forgiven for wanting to bury her head in the sand. In hindsight, doing just that (preferably while wearing masks, distancing, and exercising frequent hand-washing) has been the healthy and smart move, particularly regarding the markets.
Below is what I hope is a quick yet broad summary of some of our “Big Picture” views and inputs into our investment work. I hope it puts some context to what you’re seeing in the portfolio.
We all know that after an initial successful effort to “bend the curve” starting in early April, daily case volumes spiked, and the window is closing fast for reducing infections to a sufficiently low number before the next cold and flu season. The window may already be closed.
To state the obvious, none of us have real experience with a large pandemic threat like this. The virus is a novel, non-human virus, and it will take some time to understand COVID’s virulence, mutation, and more. The consensus seems to believe that either a vaccine or therapy can be completed this year or next, and that’s possible given the whole world is focused on this single puzzle. But optimism has to be coupled with the reality that such breakthroughs may take years, if at all, and even then, nothing may be perfect.
Like with the virus, we have never seen such a large attempt by fiscal and monetary policymakers to soften the economic blow and inject cash into markets, including business and individuals.
Over a decade ago during the Great Financial Crisis, the rescue efforts from governments and The Federal Reserve were as large as they were controversial. The ensuing economic recovery (tepid as it was) and booming asset prices—all without the skyrocketing inflation many feared—have led to a more favorable view of the bailouts, stimulus measures, deficit spending, and money printing back then.
More significantly, the “success” of policies back then has convinced policymakers that their capacity to “help” is immense, if not unlimited. There seems to be no controversy or worries about deficits and money printing.
Washington is united in a belief that it must do all it can financially during this historic pandemic and economic fallout.
This year the Fed and Treasury, with backing from both political parties, acted quickly in injecting trillions of dollars into the economy, in amounts already many times that of 12 years ago and with new and creative measures.
While the Congressional Budget Office projects an annual deficit of $3.7 trillion in the current fiscal year (which would be over 2.6 times that of the previous record set in 2009), many estimates point to a deficit closer to $5 trillion, which seems plausible given how the U.S. hasn’t stemmed the COVID tide as was previously anticipated.
Money printing has also exploded. The Fed’s “Balance Sheet” is really a measure of its assets. When the Fed wants to inject money into the economy, it “prints” new money (that means push a few buttons on a keyboard) and then buys bonds or otherwise makes loans (including to new facilities set up by Treasury). Cash enters the marketplace, and the “money multiplier” does its thing: turning a dollar into many dollars as cash is deposited into banks, which turn around and lend almost all those deposits to people and institutions who then, in turn, deposit money into banks, and over and over again.
As the chart below shows, not only was the Fed unable to remove money after the economy was in the clear after the Financial Crisis, it printed more. And then had to print some $3 trillion more with the onset of COVID.
Worrisome as this may be to many for the future of the country (if only because of a reasonable fear that debt and deficits could result in many undesirable consequences), deficits and money printing have long been larger abroad.
The combined GDP of the Eurozone (which are the 19 of the 27 countries of the European Union that have adopted the Euro as official currency) is almost half that of the U.S., and yet its central bank has a bigger balance sheet. The Eurozone has used and relied on monetary stimulus (and debt) to a far greater degree than the U.S.
The king of deficits and debt, however, is Japan. The world’s most indebted country requires constant money printing. The Bank of Japan prints money to buy bonds and makes loans to get cash into the economy. It even prints money to buy Japanese stocks!
Japan’s economy is less than 25% that of the U.S., yet Japan has a central bank almost of equal size (90%).
COVID has been a time of extremes in economic data. GDP and employment have plunged quickly and in amounts greater than any other time, including the Great Depression. And yet, with government help, there have been record breaking numbers on the upside in Personal Income. Money printing and bond buying, PPP loans, stimulus checks, and federal unemployment payments have injected unprecedented amounts of cash into the economy.
M2 is a popular measure of money that includes cash, checking and savings accounts, certificates of deposits under $100,000 and money market funds. The amount of money and near money increases consistently, but the increase has accelerated. M2 is about $18.3 trillion today, in case you were wondering. It was $8.6 trillion ten years ago.
Spending time thinking about and quantifying the stimulus not only works to understand the policies and help being given, it may also help explain what’s going on in markets. While the market is fearful of COVID and the economy, it also acknowledges that the money has to go somewhere, including bonds and stocks.
Recently, stock market averages have been rising, but the gains have been primarily driven by the largest of the large stocks, primarily technology companies. We focus on the differences and disruption brought by COVID, but the crisis has also reinforced, and even accelerated, multi-year trends already in place, including the leadership of “Big Tech.”
Years of performance leadership in Big Tech have accelerated this year, both during the market’s fall in the Spring and during its recovery since. Just five companies now comprise some 23% of the S&P 500. Take away their performance and the S&P is negative this year. (Note: the chart above is more than a week old.) Big Tech is bigger than it was during the 1999 Tech Bubble (notice only MSFT was part of that generation’s group of Big Tech). However, unlike back then, Big Tech is (1) truly profitable; (2) growing profits much faster than the rest of the market; and (3) comprising a larger and larger percentage of total corporate profits.
Stocks are historically expensive by conventional measures, including P/E. Big Tech stocks’ price gains have been about profits, but also about investors willing to pay up for their quality, growth, and great balance sheets. The Big Five alone have $395 billion in net cash between them (cash minus debt), one reason the market puts their combined value at $6.8 trillion.
Leadership in Big Tech as well as long time outperformance of U.S. economic growth, market performance, and the dollar are long in the tooth. When the performance changes, we don’t know. We think a good amount in equities, especially the kinds of companies we seek—those with durable competitive advantages, growth, quality, and good management—are still part of a sensible investment strategy.
One has to remember not to get too hung up about P/Es as they don’t exist in a vacuum. A big determinant of the P/E the market assigns is investors’ opportunity costs, (or other options). The biggest option perhaps being in bonds. When one can get a nice yield (with virtually no credit risk) in Treasury securities, one doesn’t want to pay up for stocks, all things equal. Today’s historically low interest rates suggest everything is expensive, especially bonds. One can invest at today’s 10-year Treasury rate and double their money in…116 years. Or, one can take a chance on stocks with dividends and potential growth. Value is relative.
Another argument for the bulls’ case: investor optimism may not be as high as people think. Those crying stock bubble would have a hard time showing that investors have binged on stocks.
The chart below shows how investors have rather binged on bonds and money market funds, funding those purchases by selling stocks.
But we’re looking for signs and inflection points. COVID and the upcoming election should be leading determinants of performance and a possible change in leadership. Some symptoms of change are already out there. We’ve noticed the dollar’s strength has reversed recently and wonder if it’s due to a combination of the U.S.’s relatively poor handling of COVID and an anticipation of a Democratic election sweep with higher taxes and regulation.
We have built a hedge against dollar weakness and, more importantly, against a world digging deeper into debt and printing ever-greater amounts of money. While central banks and governments can likely continue printing and borrowing without recourse for quite some time (the past 12 years may be proof of that), the potential risks and unintended consequences are still many, even if they are unknown. And those risks could be mounting. We just don’t know what happens next, and we know far less about “when.”
The gains in gold and other precious metals are no cause for celebration. Everything is relative, gold is going up because the dollar and other fiat money are going down. We think of gold like term life insurance: One does not want to make money on either!
For now, we are as balanced and diversified as we have ever been; Quality stocks, some U.S. Treasurys, Precious Metals, Treasury bills, cash, and a small amount of Australian dollars seem sensible in a dangerous and volatile time. As always, we have liquid holdings and an ability to pivot or shift when we feel it is time to do so.
We are building out contingency plans for a number of possibilities.
As always, we appreciate your trust, confidence, and loyalty. Please don’t hesitate to call or email if you have any questions.