2Q2020 Newsletter – Why Are Markets So High?

Skip Jake’s Take and Download the Full Q2 Market Review slides here.

Congratulations on making it through the 582nd day of 2020, you’re doing great!

Despite the S&P500 having its best quarter since the late 1990s, investors seem anything but excited about the markets.  If you feel anything like those with whom I’ve chatted over the past couple of months, you may feel as if things couldn’t look any worse!  As one successful, intelligent and well-informed friend of mine claimed, this market “presents a once-in-a-lifetime opportunity to avoid losses in [their] portfolio.”

I’m not an economist (though I did watch Ben Stein play one in Ferris Bueller at least a dozen times) but if it’s true that we’re teetering on the edge like 1987, 1990, 2000 or 2008, I wonder why the stock market (read: institutional/smart/big money) isn’t scared?  After all, the vast majority of money being traded in the markets is that of big institutions with access to the brightest minds, best information and biggest accounts and simply put, their selling doesn’t seem in line with the panic many Americans are feeling. Why don’t they see what we see, and importantly, why are they buying into this market?

Let’s get this out of the way: I don’t like making (public) predictions on the short term moves of the markets – there’s too much irrationality and it’s too much like gambling.  Investing isn’t the same as gambling; one focuses on short term returns and generating bursts of emotions and the other is boring,  focusing on the long term and benefitting from company growth and the tailwinds of inflation, improvements in efficiency and other factors mostly attributable to time and success.  Yet I’m going to go against everything I learned in “How to be a Financial Advisor” and make a public guess as to what the next six months in the markets are going to look like: Very bumpy…in my professional opinion.  But remember, these bumps aren’t based on what’s happening today or what’s expected a month from now; most of that is already “baked in” to current prices as the market is the great “discounter of information.”  Does this mean we can’t or won’t have a sell-off over the next 6-12 months?  Of course not; but you can’t invest over a 6-12 period – only gamble.  Investors aren’t concerned with 6-12 months from now, they’re interested in what their portfolios will do over the long term.  And if you focus on the long-term, the market gyrations we’re experiencing today, and those we’re likely to experience in the coming months, will seem much smaller.  That said, let’s look at the factors most likely to drive market volatility in the coming months, and why the impact may be short-lived.

Base Case – In most analyst reports, they include a bear case, i.e., what the analyst thinks may happen to the stock/index/bond/investment in a worst-case scenario, a base case for what they actually think will happen, and a bull case – a best case scenario.  For purposes of this newsletter, let’s assume the base case has a 50% or 60% likelihood, with one half of the remainder distributed equally on either end of the curve.  With a nod toward the shoulders of the curve, we’ll focus on the head – the base case – as I’m confident most readers recognize the drivers of the bear case and admittedly, I view the bull case as less than 20% likely.  So, let’s look at some of the drivers behind the base case – what I believe the market has already priced in – and their implications for market returns.

Coronavirus – Coronavirus cases and deaths will, tragically, continue to go up.  We know this because A) they can’t go down and B) even if everyone wears a mask starting today (PSA: wear a mask), there will still be transmission, albeit at a significantly reduced rate.  The market has accepted that the virus will be here for at least the next 6-18 months, that hotspots will pop up, cyclical shutdowns will occur and rising death counts are inevitable; yes it’s sad, but as with everything in the market’s history, it has become our new normal and markets have accepted and adapted to it.  This is now our base case.  Barring an unexpected, significant deviation from this base case, we shouldn’t view a spike in cases or deaths as a threat to the mid and long-term performance of the markets.  Sure, there’s headline risk (and there will be headlines), but the rising numbers won’t change the market’s underlying assumptions.

Government Interventions – To date, the Federal Reserve and Congress have taken swift actions to get money into the American economy, both directly to consumers via helicopter money (stimulus checks), Paycheck Protection Program (PPP) and EIDL Loans, and indirectly with quantitative easing by purchasing bonds (both government and company-issued!!) in both the primary (direct from the issuers) and secondary(!!) markets (after the securities have been issued and they begin trading).  Additionally, the Fed has reopened the Great Recession playbook and lowered the bank-to-bank overnight lending rate (Fed Funds-rate) to near zero.  They’ve created backstops for money market mutual funds, lowered the discount rate (rate the Fed charges banks to borrow directly from the Fed) and temporarily relaxed regulatory requirements to encourage banks to lend more to consumers – among many other steps taken.  Reminder that betting against stated Fed policy (or the unlimited money-printing supply of the Treasury) has not been a good long-term bet.

To date the government has shown their willingness to do whatever it takes to stave off the virus’ economic impact, pumping trillions of dollars into the economy with trillions more likely in fiscal (think tax/Congress) and monetary (think Fed) stimulus.  At this point, investors know that if things get bad enough, steps will be taken to ease the pain and markets will be supported with the Fed coming in as the “angel” investor and buyer-of-last resort.  This has become the base case –the Fed as protector of the markets.  Arguments that the Fed has no more bullets are untrue, and we may see some new tools pulled from their belt in the coming months.  Knowing that the Fed will prop up the markets means there’s less willingness to sell.  This moral hazard combined with the unprecedented money being pumped into the markets are the primary reasons for the market’s rebound.  Barring significant deviations from full-throated commitments by the Fed (or Congress), Monetary and Fiscal policy should have little effect on the base case.

Presidential Election – I’ll try to mind the gap but my apologies in advance if I land too close to the third rail here – when dealing with politics it’s difficult to avoid the economic impacts.  In short, I view the uncertainty around the election and associated questions (VP and cabinet choices, reactions/behavior of incumbent as election nears, etc) as likely the biggest driver of volatility in the coming months due to its mid and long-term potential impact on the markets.  I expect the coming months will be turbulent due to the upcoming elections.

Uncertainty is the primary driver of volatility in the market and nothing screams uncertainty like the potential for a changing administration and Congress.  Surprisingly, despite polls showing a significant lead for Joe Biden, the markets don’t seem overly worried, or perhaps view it as too early to be a realistic threat.  As last week Barron’s pointed out, there’s likely a belief that a Biden administration would first focus on shoring up the economy and getting money into the hands of consumers, rather than prioritizing the roll-back of tax cuts under the Tax-Cut and Jobs Act, widely seen as disproportionately benefiting the wealthy and large corporations.

The base case here is for increased volatility.  If my record on short term market swings is 50%-60%, my record on presidential outcomes is substantially worse.  As such, I won’t offer any guesses (bets) as to who will win, other than those long volatility.

Closing Thoughts and Tips

To those still awake, this newsletter was intended to help you see the institutional argument for why stocks are trading where they are; think of it as one answer to “the world is in chaos why are stocks going up?”  It is intended to help you pause, take a deep breath and zoom out.  Of course, this is an overview of what I see as the primary drivers of volatility in today’s markets. Unemployment/underemployment, wages, inflation, geopolitical tensions (remember those?) and other factors can lead to market rallies or meltdowns.  While there are certainly reasons for concern, remember to focus on the factors that can impact the markets over your investment horizon.

If you’re still struggling to remain disciplined (read: invested) consider using buckets based on your investment horizon.  Buckets help put portfolio volatility into context.  Watching account fluctuation in a bucket you know won’t be touched for 10+ years is substantially easier than watching your entire nest egg fluctuate.  Broadly speaking, money needed in the coming year or two shouldn’t be invested in the markets; it should be in a “high” yielding savings account.  Beyond that, consider breaking your money into three buckets based on when you anticipate needing access to the funds.  Consider a 2-4 year bucket for low risk, lower return investments, 4-8 year for mid risk/return and 8+ year bucket for your high growth, higher risk investments.  While some people can do this psychologically, others need to open multiple accounts to help manage their emotions.

Discipline in turbulent markets is difficult, but enduring this difficulty is the necessary tradeoff for higher expected returns.  In the end, it’s your money and if you can’t sleep or it’s causing too much anxiety, maybe it’s time to reevaluate your allocation and consider a less-risky portfolio.  After all, it’s better to do it now than during the next market sell-off.  Just make sure your new allocation is something you can live with for the long-term.

Download the Full Q2 Market Review slides here.