The Russell 3000 Index has risen 51% from the initial economic shock of the COVID-19 pandemic – specifically, March 23rd through the end of the third quarter. That is an incredible recovery for stocks. Though some might say it’s overly optimistic, there are clear reasons for the market’s sharp rise. As investment professionals, we are humble enough to know that markets sometimes see things differently than we do and are often more prescient than any individual.
Multiple factors support the equity market’s upward momentum:
- The Federal Reserve’s unprecedented monetary support in response to the pandemic has significantly expanded the money supply. M2, a basic money supply measure, is up 23% year over year – that’s significantly higher than the 4%-6% increase in a typical year and even the 8%-9% increase that marks a bullish year. The velocity of that money being reinvested into the economy will drive growth. (See Chart A: Money Supply Growth.)
- Economic recovery is well underway. Throughout the summer, the forward-looking economic data that we follow – employment, corporate earnings, global and US purchasing managers’ indexes (PMI) – all surpassed expectations.
- Asset allocators currently prefer equities to fixed income. They will continue to do so as long as the Federal Reserve provides a backstop for capital markets through its monetary policy.
In the context of these drivers, current market behavior appears at least somewhat understandable. It’s true, there have been some signs of speculation, which we talked a bit about last quarter, but these appear secondary to the structural support for equities. It’s also true that equities are expensive. However, history tells us stocks can stay expensive for quite a while without a downturn, and in this case, they probably will until real interest rates start to rise. Support from institutional asset allocators, which we noted above, is likely to hold firm given concern that excessive caution will mean missing out on big returns. This “fear of missing out” is itself a sign of speculation but is definitely a factor driving the rally.
Further Economic Recovery Hinges on Fiscal Stimulus and Reopening
Following the positive economic news of the past three months, investors are trying to make sense of how short the COVID-19 recession has been. They want to know whether the Federal Reserve’s rapid response short-circuited the recession or just kicked it down the road. The answer depends on fiscal intervention, aka government spending, and the pace of economic reopening.
As the fourth quarter gets underway, the recovery rate is slowing, and the economy needs another adrenaline shot. That’s probably not going to happen organically, and monetary policy has gone about as far as it can. The next economic boost depends on the federal government. Both houses of Congress and the Trump administration are debating the terms of a new COVID-19 relief bill. It is doubtful agreement will come before the election, but we expect a stimulus package soon after, regardless of the outcome on November 3rd. We are hopeful that future stimulus will provide targeted support for small businesses – the area of the economy where jobs are created. That would really spark momentum.
Expanded reopening is also vital. Though COVID-19 cases are rising in multiple US states and Europe, treatments appear more effective in speeding recovery and lowering the mortality rate. Vaccine and further therapeutic development appear promising. Meanwhile, many forward-looking economic and investment sentiment numbers remain positive. People and markets seem more confident that economies can withstand the impact of COVID-19 no matter what happens. This is a major turnaround from March when fear was the overriding emotion, and the virus’s ultimate lethality was a complete unknown. Now we can at least envision an economic path back to some kind of normalcy. No one can be 100% sure that will happen, but expectations are a good deal more optimistic than they were in the darkest days of March.
COVID-19 Is a Catalyst for Lasting Change
Some developments of 2020 may change how we look at markets and how markets operate well beyond this year. Economic stimulus has spurred unprecedented growth in US debt. From our founding through 1981, the US accumulated about $998 billion of debt. Now Democrats and Republicans are proposing numbers ranging from $1.5 to $2.5 trillion for a single stimulus package. Obviously, the pandemic is driving this need, but staggering debt may be a more lasting affliction. As long as there is a political will to restrain social and business activity in order to combat the pandemic, further stimulus will be necessary, and debt will continue to accumulate.
COVID-19 is also driving secular trends that were already developing, but more gradually and at different rates. Now many of these trends – work from home, shop from home – have coalesced and accelerated, with the potential to affect economies and markets well into 2021.
We spoke recently with a European strategist who made a distinction between diverse portfolios and what he called “anti-fragility” portfolios. His comments on diversification coincided with some of our own thinking that traditional diversification may not be as protective as it once was.
This plays out across asset classes as well as industry sectors. Bonds are a traditional diversifier that appear more fragile in the current environment. We remain concerned about a bond allocation’s ability to cushion a portfolio. In a classic economic cycle, business activity slows, and the Fed lowers interest rates to spur activity. Slower business activity lowers corporate earnings, causing equity prices to fall just as interest rate declines raise bond prices. Portfolio diversity provides a hedge because bonds are rising while stocks are falling.
Today, with bond yields at historic lows, particularly the 10-year US Treasury, there is little room for price appreciation. So, we don’t see the diversification bonds previously brought to the table. Consequently, we are looking for other elegant solutions. For example, in some instances, we have added gold as an alternative asset to increase portfolio diversity.
The same European analyst shared with us his view that the alternative energy and big tech sectors appear more resilient or “anti-fragile,” while oil and gas stocks seem more vulnerable to downturns. As an illustration of how much has changed over a short time, in December of 2019, Exxon Mobil’s market capitalization was $300 billion and Zoom’s was about $25 billion. Just nine months later, Exxon’s market cap fell to $143 billion and Zoom’s rose over $150 billion in late October.
Will Inflation Finally Rear Its Head?
Ever since the US went off the gold standard 49 years ago, the US Federal Reserve’s mandate as the country’s independent central bank has been to fight inflation while supporting employment. Independence was crucial because it gave the Fed the ability to rein in politicians, keeping them from printing money to influence elections and thereby weakening the currency. However, between 2008 and now, central bank policy has been attempting to bring on inflation rather than dampen it. Pitcairn has put strategies in place to protect against inflation that has never arrived. We maintain that investors must still guard against the threat of corrosive inflation due to the massive monetary and fiscal policies enacted in 2020.
Regardless of who wins the election, I believe we will see federal policies designed to drive economic growth and raise interest rates. If the Democrats take control, we will likely see more government spending. If there is a second Trump term, we could see tax cuts and other supply side fiscal policies. Either way, there should be some modest inflation, which would not be a bad thing at this time. Fed Chair Powell has indicated the Fed is not going to step on the brakes in response to the first signs of inflation. Instead, the Fed has made clear it will keep interest rates lower for longer. And low interest rates lift asset prices, as we have so clearly seen this year.
The risk in this strategy is if eight to nine months from now, the combination of fiscal and monetary policies has not led to normal levels of business activity and higher interest rates, but rather to some sort of stagflation – inflation without rising GDP – the Fed would need to reverse its monetary policy, thus creating challenges for risk assets.
Politics and the Tech Stock Rally Raise Short-term Concerns
The notable theme underlying capital markets in times of political uncertainty is one of caution. Markets are undoubtedly susceptible to fear and may experience short-term pockets of volatility. But I return to my belief that we, as humans and investors, tend to overestimate short-term risk. While the “wall of worry” is currently very high, it is very hard for me to foresee equities performing poorly relative to other asset classes as long as the Fed maintains its current posture. Going forward, I believe market performance will be more about core economic factors than short-term uncertainty.
One particular risk I think investors are overestimating is the potential for a blue wave that pushes the entire US political system immediately to the left, resulting in new taxes and regulations that crush corporate earnings. Even if the election favors the Democrats, there have been many periods when one party controlled the presidency and both houses of Congress and that party discovered that realizing their political objectives was still painstaking and time consuming. There is no reason to think that a Biden administration would have an easier legislative path than the unified governments of Presidents Obama, George W. Bush, or Trump. Further, Democrats are taking over an economy in a precarious state. They will likely be careful, particularly in the administration’s early days, not to do anything that stifles economic recovery.
Through the spring and early summer of 2020, a relatively small group of stocks – mainly a tech train – had been driving much of the equity market’s return, a cautionary sign. However, a positive trend of the past quarter has been the broadening of equity market leadership. During the brief secular retracement in September, technology, which had rallied significantly in July and August, gave back some of its gains. Conversely, industrials, basic materials, and consumer discretionary performed well and have continued to do so. Now, gains have become more broadly participatory. That is a different scenario from 1999 where technology stocks rose and everything else languished.
In another sign of a broadening market, small cap stocks outperformed large cap by 3.5%-4% in September. This has raised some concerns about small cap valuations as many small cap companies either don’t yet or don’t currently have earnings. Some small companies in the index might not have survived in other environments but have been able to leverage their balance sheets. Small caps are experiencing inflows from asset allocators at a pace we have not seen in several years. That is not what we would expect from a “last gasp” technology-driven bubble about to pop.
Elsewhere, Asia has experienced far less economic damage than other regions, and businesses there have returned to normalcy at a much higher rate than the rest of the world. As a result, emerging markets, with China at their core, staged a bit of a recovery over the summer. They could continue to perform well relative to the US if they avoid a regional resurgence of the pandemic and may also benefit from a modestly weaker dollar that will certainly come with a Biden administration and the Fed’s continued easy money stance.
Broader participation across US sectors and market caps, as well as recovery in emerging markets, are positive signs for equity markets.
Steady at the Wheel
This is the time of year we typically host our annual Wealth Momentum Forum, and we are disappointed that the pandemic prevents us from gathering this year. You may remember that our 2019 Forum occurred just as the presidential primary season was heating up and we took the opportunity to share some thoughts from Warren Buffet. With the election upon us, it seems appropriate to highlight Mr. Buffet’s words once more:
“People who mix their politics up with their investment activities, I don’t think that makes sense. I’ve watched it all my life and, obviously, probably half the time of my adult life I have had a president other than the one I voted for, but that has never taken me out of stocks. The American economy – we are up to number 45 or so – and we have done awfully well. If you mix your politics with your investment decisions, you are making a big mistake.”
These words of wisdom from one of our country’s most successful investors are well supported by historical results. As you can see in Chart B: Political Parties’ Effect on the Stock Market, neither political party has a monopoly on strong stock returns. Equity markets seem to be indicating they are fine with either presidency. If markets were afraid of the political situation, they would not be rising. I encourage you to focus on your long-term goals, hold firm to your investment plan, and not let the political season sway you off course.
As always, we extend our best wishes for the health and well-being of you and your family during these challenging times. If we can assist you in any way, please contact us.