Good Morning,
Stocks fell sharply on Friday as gold spiked and the 30-year treasury bond yield hit an ALL-TIME low after the number of new coronavirus cases escalated, fueling worries over a pronounced global economic slowdown.
China’s National Health Commission reported more than 75,000 confirmed cases and over 2,000 deaths on the mainland. More than 800 new cases were reported in China overnight. South Korea has also reported more than 200 cases.
Meanwhile the service sector PMI reading hit its lowest level since 2013 while the S&P 500 forward PE ratio hit its highest level in nearly 18 years. That number is well above recent trends, eclipsing five, 10, 15 and 20-year averages while the bond market “screams” ever louder at the increasing disconnect between its outlook for the economy and that of the stock market, which has been signalling increased optimism for growth stocks.
Our Take
Many pundits who remain constructive on the stock market have pointed a finger at the outbreak’s effects regarding the recent defensive rotation but there is likely more to it than a simple near-term hit to corporate earnings. Why? Well so far this year, utilities and bonds have BY FAR outperformed the broader market and the bond rally has been going on for some time now.
Simply put, there are many conflicting signals out there. Besides the virus issue, many market participants view the present stock market as overpriced. The view from a technical basis seems to support this. Furthermore, since the October lows, the S&P has been trading in a range that is 9-11% above the 200-day moving average while sentiment indicators flash extreme greed and speculative trading among retail investors has pushed story stocks like Plug Power (NYSE:PLUG), Tesla (NYSE:TSLA) and Virgin Galactic (NYSE:SPCE) to eye watering heights.
Credit conditions are loose, risk taking behaviour is high and capital is abundant; all “late cycle” market signs. Based on the above, many have posited that the market is now “overvalued” or uninvestable with even the eternal bull Warren Buffett in his latest annual letter, warning that debt should be used sparingly, current stock market valuations are “sky-high” and “anything can happen to stock prices tomorrow…[as occasionally]...there will be major drops in the market, perhaps of 50% magnitude or even greater”. Not exactly his usual light and airy bullishness...
What to make of all of this? As always, market cycles present the investor with a daunting challenge given that:
-Their ups and downs are inevitable
-They will profoundly influence our performance as investors
-They’re unpredictable as to extent and, especially timing
On a short term basis, a “breather” was likely necessary given the overbought conditions coming into 2020, yet as for the medium to longer term outlook for stock ownership we believe that it is likely no longer possible to be “macro agnostic”. What does this mean?
A hint can be found in Buffett’s recent letter cited above:
“If something close to current rates should prevail over the coming decades and if corporate tax rates remain near the low level businesses now enjoy, it is almost certain that equities will over time perform far better than long-term fixed-rate debt instruments.”
If we deconstruct the long-term bullish thesis it is roughly that: 1) easy money conditions will continue with an accommodative Fed and a president that wants a roaring stock market at all costs 2) full employment conditions 3) high U.S. consumer and business confidence and 4) demographic tail-winds: ie. millennials that are reaching peak income who will fuel the next phase of growth in personal consumption prolonging the bull market cycle.
Let’s focus on point 1 to illustrate what we mean regarding the impossibility of being macro agnostic.
EPD Macro Research has provided an excellent analysis demonstrating that throughout history, the economic cycle has been a significant driver of asset class performance. The research points out that when economic growth is improving, stocks deliver strong returns, diminished volatility, and interest rates generally rise. As economic growth slips and moves into a downward trend, stocks generate muted returns with heightened volatility, while bond prices surge.
During the past two years, economic growth has undeniably weakened in the United States. Despite the material weakening of the US economy in the past year, BOTH stocks and bonds delivered returns that exceeded their historical average.
The strong performance in Treasury bonds is less of a surprise as declining growth is generally favorable for bond prices. Stocks over the past year and a half, however, have generated a risk-adjusted return nearly 3x the average ratio seen during periods of declining growth.
Treasury bonds have followed the economic cycle with impeccable precision, generating slightly stronger gains than past samples of "below trend" growth. Treasury bond investors have been rewarded for following the direction of growth.
As long as economic growth remains in a downward trend, history and the fundamentals of economics argue that Treasury bonds will continue delivering strong risk-adjusted returns relative to other more cyclical assets.
The question is why stocks have performed so abnormally given the weakening in economic growth? The answer is to be found in Buffett’s suggestion above RE: rates and corporate tax- in other words, pillar 1 of the bull thesis.
Under the above framework, like it or not, the investor by allocating his portfolio cannot help but make an implicit decision about where he/she believes growth and interest rates (monetary policy) are going over the long term. Thus, investments in stocks under current conditions are explicitly and implicitly based on large sets of forecasts about the future.
What can be gleaned from the above RE: putting new money to work today?
First and foremost, equity investors should likely reduce their expectations for returns and especially so for individual stocks that have deviated not only in degree but also in direction, rising significantly during a period of declining growth.
As long as economic growth remains in a downward trend, history and the fundamentals of economics suggest that Treasury bonds will continue delivering strong risk-adjusted returns relative to other more pro-cyclical assets.
Can we expect a statistically significant rebound in growth? Based on what we’ve seen, global growth indicators are likely to further slow this year with the impact of the Corona virus, taken together with slower growth in the labor force and the shift to services which continue to act as a drag on growth in the developed world. As such, we see rates continuing to go lower until further loosening of financial conditions and stimulus become politically untenable, or until such “financial engineering” loses its effectiveness due to diminishing returns.
Does this mean the way forward is to sell stocks in order to buy bonds, cash equivalents and gold in drag? In this monetary environment, such a “boycott” of the equity markets would be unwise, yet until we see more convincing evidence of a cyclical upturn, reducing leverage, realizing outsized returns, tempering expectations for equity returns and preparing for big drops in the equity market (mean reversion) would be recommended. Macro-agnostic in this environment? We think not.
Stock Ideas
Our piece on New Relic featured on ValueWalk.
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Musings
On a lighter note, one thing I would also recommend in any market but perhaps even more so in this market, is the practice of gratitude.
My mother sent me a simple thought provoking video about the subject recently.
At a time when the indignities and absurdities of our contemporary economy - with its yawning inequality, super-powered corporations, outsized returns, billionaires battling for the presidency, extreme narcissism and obsession with optimization and productivity - are more glaring than ever, it is important to reflect on how much we have to be grateful for.
How lucky are we to be in a situation where we can drive our own cars, run our own businesses, send our kids to publicly funded schools, have enough to even discuss making a return on investment and of course have our basic needs met? At a time when consumer and business confidence is at record highs, and we have the luxury of protesting for higher wages, more benefits, the eradication of entire industries in the name of the planet, as well as more of anything and everything, it is so easy to overlook just how good we have it in developed countries.
Let's remember that by having:
Food
A hot shower
A job
Lights that turn on at night
Clean clothes on our backs
A bed
A Floor in our homes that isn’t made of dirt
Freedom from being shot at, raped or robbed
Friends or family
Opportunity: we can turn things around and have a good life
We have more than most people on this earth.
So the next time that feeling of frustration, anxiety or outrage washes over you, whether about the IRR on your project, the CAGR on your portfolio, the so called death of the American Dream, the amount of traffic/likes on your Linkedin/Instagram posts or whether or not you are getting your “fair share” of whatever pie you are concerned about, think about the inverse.
What do you have to be grateful for today? What makes waking up in the morning a blessing instead of a curse? You may be surprised by the great abundance you find.
As we navigate “Late-Capitalism” with its social, moral and ideological rot and wonder what comes next, I think much of the answer can be found in the practice of gratitude.
Charts of the Month
Loan rates are making new new historical lows.
Mortgage delinquencies are at record lows
Thought of the Month
"Happiness cannot be traveled to, owned, earned, worn or consumed. Happiness is the spiritual experience of living every minute with love, grace, and gratitude.”- Denis Waitley
Articles and Ideas of Interest
The new generation of self-created utopias. As so-called intentional communities proliferate across the country, a subset of Americans is discovering the value of opting out of contemporary society. Rachel Fee, a 39-year-old herbalist, moved to Earthaven in 2017 after five years living outside Asheville, N.C. She wanted a more communal lifestyle that fit her ideals and didn’t push her to work relentlessly; here, she’s no longer “inundated with the idea that productivity is your self-worth,” she said. “This is not an idealistic situation,” she said. “It’s not running away from the world and sticking our head in the sand — it’s reinventing the wheel.” Interesting piece profiling such communities as well as their members citing academic studies done on such communities which have suggested that happiness levels within them are superior due to the fact that living in an intentional community, “appears to offer a life less in discord with the nature of being human compared to mainstream society.” Why? “One, social connections; two, sense of meaning; and three, closeness to nature.”
Are we alone? Something in space is sending radio bursts to Earth at regular intervals. Scientists are still debating what is creating the waves, which follow a steady 16-day cycle.
Why are there so few female CEOs? To become a company’s chief executive, it helps to have held a role with profit-and-loss responsibilities, such as heading a division or brand. Unfortunately women rarely land such positions, and more often end up heading human resources, administration, or legal. For the Wall Street Journal, Vanessa Fuhrmans examines the reasons for that, and highlights a company bucking the trend.
Stories Matter: CEOs who mention ‘growth’ on earnings calls see outsized stock gains. S&P Global Market Intelligence finds that CEOs who used buoyant language to describe revenue, earnings or profitability outperform counterparts. Russell 3000 executives who mentioned buzzwords like “growth” and “improvement” saw some of the most significant outperformance.The study represents the latest chapter in a long body of literature that seeks to determine how, if at all, executive commentary and guidance impacts returns.
An unsettling new theory: There is no swing voter. What if everything you think you know about politics is wrong? What if there aren’t really American swing voters—or not enough, anyway, to pick the next president? What if it doesn’t matter much who the Democratic nominee is? What if there is no such thing as “the center,” and the party in power can govern however it wants for two years, because the results of that first midterm are going to be bad regardless? What if the Democrats' big 41-seat midterm victory in 2018 didn’t happen because candidates focused on health care and kitchen-table issues, but simply because they were running against the party in the White House? What if the outcome in 2020 is pretty much foreordained, too?
Younger workers feel lonely at the office. They have friends at work and good relationships with their managers. But younger employees still feel alone at the office, according to a new survey. More than 80% of employed members of Generation Z—many of whom are just entering the workforce—and 69% of employed millennials are lonely, according to a survey of more than 10,400 people, including about 6,000 workers, in the U.S. from health insurer Cigna Corp.
Climate models are running red hot, and scientists don’t know why. The simulators used to forecast warming have suddenly started giving us less time.
Why China is still so susceptible to disease outbreaks? China has become an epicenter for disease outbreaks, and the problem lies in its food supply.
We are only in the early innings of the enterprise cloud software revolution. Enterprise software is in the midst of a structural shift toward cloud-enabled platforms. In-house systems, localised IT teams, unsupported third-party software, and expensive solutions by incumbents present a major market share opportunity. The legacy moat attributed to customer stickiness and high switching costs has ended. We are now witnessing an inflection point, driven by several technology evolutions, which will reward new and innovative players.
By nearly every measure, the venture industry has boomed.Venture capital has evolved from small-scale, hyperlocal deals to a global industry that invests $250 billion each year. Quartz contributor Dave Edwards reports on the forces that transformed VC—and lays out what the explosion of private investment means for all of us.
If you’re so smart, why aren’t you rich? How much is a child’s future success determined by innate intelligence? Economist James Heckman says it’s not what people think. He likes to ask educated non-scientists -- especially politicians and policy makers -- how much of the difference between people’s incomes can be tied to IQ. Most guess around 25 percent, even 50 percent, he says. But the data suggest a much smaller influence: about 1 or 2 percent. So if IQ is only a minor factor in success, what is it that separates the low earners from the high ones? Or, as the saying goes: If you’re so smart, why aren’t you rich?
Inside the mind-bending world of political disinformation. Atlantic reporter McKay Coppins investigated pro-Trump propaganda on Facebook from the inside: Creating a fake profile and “liking” conservative-oriented pages quickly took him down the rabbit hole of how the US president’s re-election campaign combines microtargeting, sheer volume, and misleading content, among other tricks, to ignite his base and question the concept of truth.
Our best wishes for a fulfilling February,
Logos LP