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We want to share our thoughts about how we view markets and the economy today. This year more than ever should remind investors that predicting the future is virtually impossible, especially in the short term. But even in our darkest hours, we remain optimistic that the best years are ahead.
LONG TERM OUTLOOK – THINKING IN DECADES
We believe now is the time to stay focused on your long term goals and think in decades. The resilience of the global economy and human ingenuity will continue to progress into the 2020's - 2030's as has been the case throughout the 20th and 21st century to date. The acceleration of technology and innovation continues on an exponential curve. Private businesses continue to create meaningful value for their customers and shareholders, driving both enhanced goods and services while focusing on long term sustainable revenues and profits. This foundational belief compels us to recommend diversified global publicly traded companies as the engine of long term growth and wealth creation in portfolios. Thus for long term investors, this led us to stay invested going into the shutdown and continue to remain invested going forward.
NEAR TERM OUTLOOK – THIS YEAR AND BEYOND
In the near term, we believe there is a disconnect between the market's recovery and the current economic backdrop. At the market lows in March, the Forward Price to Earnings (PE) ratio for the S&P 500 stood at 13x, the lowest level seen since 2013. In just over two months' time the Forward PE now stands at 21x - the highest level since the financial crisis. While valuation metrics are notoriously bad indicators for short term market timing, as long term investors this indicates paying more per $1 of expected earnings today than in late March (or even the start of the year). Sometimes good reasons exist to trade at high valuations. Examples include expanding GDP growth (2013), expanding profit margins (2018), anticipated favorable tax policies (2017), or improvements in global trade (late 2019). However, we currently view these four themes as greater near-term headwinds than tailwinds.
In mid-April, the 2020 IMF prediction for the US was a -5.9% contraction followed by 4.7% growth in 2021. If this forecast is realized, the 2021 GDP output for the US will still be lower than the pre-pandemic 2019 level. The unemployment rate spiked from 3.5% in February 2020 to 14.7% April. And Goldman Sachs predicts the unemployment rate will peak at 25%, be 12% by year-end, and 8% for 2021. Though the economy is beginning to reopen, the gap to pre-pandemic levels remains wide.
12% profit margins in the US were near all-time highs at the start of the year, yet currently sit at approximately 10%, the lowest level since 2016. Even Home Depot, a company that has been very resilient throughout the pandemic, reported their operating margin declined from 1Q19 vs 1Q20 and suspended forward guidance for the year due to, "The level of uncertainty that exists with respect to the impact of COVID-19 on future economic activity and customer demand." Businesses must cope with revenue pressures, increased costs in supply chains, and lower efficiencies as new safety and social distancing procedures are put in place.
Personal and corporate tax rates are currently quite low. While individual tax rates are set to sunset in 2025, corporate rates are currently "permanent”. However, as elections loom and Federal deficits accelerate, it is very possible that tax rates could move higher in the near future. Higher rates for corporations in particular would add further pressure on earnings.
Since the US imposed tariffs on China aluminum and steel in March 2018, global trade policy has been a consistent theme weighing on markets. As recent as January 2020, China and the US signed a 'phase 1' trade deal showing positive momentum for global trade negotiations. As tensions rise over the coronavirus pandemic and Hong Kong sovereignty, investors must consider increased trade war risks.
SO WHY IS THE MARKET SO HIGH TODAY?
The most obvious reason for the S&P 500's +40% gain since March 23rd is the liquidity tailwind. The Federal Reserve is pushing an enormous amount of liquidity into our economy. Bond yields will likely remain low for some time. As a result, the dividend yield on stocks looks attractive compared to interest rates. On a relative valuation measure, stocks do not look too expensive compared to bonds. In short, the money has to go somewhere and it's going into the stock market.
There is also an argument to be made for fundamental changes in the equity risk premium (the excess return investors receive for taking on stock market risk). If the Federal Reserve intervenes in the market when it falls approximately 30%, are they putting in an arbitrary floor? Federal Reserve intervention changes the risk-to-reward equation, and could justify higher earnings multiples for stock market investment.
The federal government also stepped in with fiscal stimulus. The speed and size of increased unemployment benefits is very different from previous recessions. Government transfers (stimulus checks, state and federal unemployment benefits) have helped offset a large part of the decline in personal disposable income. These benefits are currently set to expire July 31st.
And it also bears repeating that the market is the ultimate leading economic indicator. On March 10, 2009 the market began a ten year rally while many economic indicators, including employment, continued to deteriorate for months during the Great Recession.
GIVEN A LONG TERM POSITIVE OUTLOOK COUPLED WITH NEAR TERM HEADWINDS, HOW SHOULD INVESTORS NAVIGATE THESE WATERS?
For those thinking in decades and already invested, stay on the ride. You have to be correct twice when you jump out of the market then jump back in based on short term measures. We've written extensively about how volatility clusters – both the up and down days - in very brief periods.
For those with short term liquidity needs, ensure those funds are set aside out of the market. Again, we wrote previously about building the 'bond tent' to weather the storm. It's still unclear on the timing for both development and global distribution of a successful vaccine.
And for those looking to put extra cash to work for long term goals, flexibility is key. Maintaining flexibility allows for consistent investing in normal times (pre-pandemic), accelerated investing when the market looks oversold (late March), and pausing when the market looks fully valued (today).
Thank you for your continued support as we navigate these volatile times.
Andy Michael, CFA
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