September 23, 2020
Note: We are breaking up our client letter into two parts due to its length, with part one focusing on our long-term view and part two homing in on the near-term environment.
In response to the global financial crisis (GFC) of 2008, central banks all over the world slashed interest rates aggressively. Due to the severity of the fallout, governments across the globe followed central bank stimulus with fiscal stimulus to bring economies back from the brink. As these efforts were not enough to arrest the economic and financial market decline, global central banks pushed the envelope with massive money printing, the likes of which had never been seen before. Eventually, there was enough mud thrown at the economic and financial wall that some of it stuck and economies and financial markets crawled out of their holes and an economic recovery and bull market in stocks was born.
In the years that followed, we saw the on-again-off-again actions of central banks printing money and then stopping to print again as they were cautious about creating the fodder for an inflationary fire that never materialized. There were many policy missteps from fiscal austerity measures that pushed Europe and the U.S. into economic decelerations and even missteps from central bankers. The European Central Bank (ECB), for example, misjudged Europe’s economic strength by attempting to lift interest rates with two rate hikes in 2011 that plunged Europe into a financial crisis with Greece possibly defaulting on their debt, only to remove those two hikes as they returned to 0% interest rates just months after hiking.
In 2010, to slow the rate of inflation, the People’s Bank of China (PBOC) raised interest rates from 2.25% to 3.5% in the middle of 2011 and squashed their economic recovery that began in 2009. China witnessed strong economic growth (as measured by GDP) of just over 12% growth in 2010 but once the PBOC began hiking rates that level of growth has not been seen since, slowing every single year for the last decade. In fact, the rate hikes in 2010-2011 cooled growth so much that China began to cut interest rates in 2012 and then more aggressively in 2015. These later efforts were unable to accelerate China’s economic growth but merely arrested the slowing that began in 2011.
The U.S. was not without its policy errors. In 2018, Fed Chairman Jerome Powell aggressively raised interest rates despite a slowing global economy, a trade war with China, and growing signs of distress in the credit markets. Powell raised rates to 2.25% on 09/26/2018 and five days later the S&P 500 began to slip into a correction. The decline stopped when Powell gave soothing words to the market and did not raise interest rates at the November 8th meeting. For the next 4-6 weeks, the stock market settled into a trading range with hopes that Powell would signal at the December 19th meeting an end to the Fed’s balance sheet reduction program (reversal of money printing) and that it would be ending its rate-raising cycle. These hopes were dashed as Powell said the Fed’s balance sheet reduction program was on “auto-pilot” despite the credit markets beginning to come unglued. These words dropped the floor under the market as the S&P 500 fell nearly 10% within the next three days before bottoming on December 26th, 2018.
Within a matter of days Powell began to walk back his tightening bias by replacing “auto-pilot” with “whatever it takes,” a complete 180 as he began to discuss stimulus efforts. Like those before him at the ECB and PBOC, Chairman Powell misjudged the fragility of the financial markets but came swiftly to the rescue in short order. 2019 turned out to be the polar opposite of 2018 as the Fed moved from hiking rates to cutting them, and from shrinking its balance sheet to expanding it. Now, at zero percent interest rates, we find ourselves back at ground zero.
Fool Me Once, Shame on You. Fool Me Twice, Shame on Me
Progress, far from consisting in change, depends on retentiveness. When change is absolute there remains no being to improve and no direction is set for possible improvement: and when experience is not retained, as among savages, infancy is perpetual. Those who cannot remember the past are condemned to repeat it.
– George Santayana
Thank you for your patience with the above history lesson as there is a point to the above recount. Our leaders, whether they be political, financial, or military, are to be resolved and resolute, to promote stability and calmness to the masses through the confidence of their leadership. For this reason, rarely do central bankers do an about-face after setting course so that confidence in their foresight is not shattered. Historically, central bankers often wait until they can see the white of the economy’s eyes before embarking on a new course, often at which point it is too late to stop the consequences of their past actions.
The lesson to be learned here is that a system which is built on a pile of debt will likely be supported at all costs to prevent a deflationary spiral like that seen during the Great Depression. Whether in Europe, China, or here in the U.S., this has been the message over the last decade. The message given by central bankers is that they have no problem showing the world they went too far and admitting they were wrong with an abrupt about-face, where Fed Chairman Powell shortened the meaning of “abrupt” to as little as two weeks when on January 4th, 2019 he appeared with his two predecessors, Ben Bernanke and Janet Yellen, and walked back his comments from the December 2018 meeting.
In light of the weakness and warning signs we saw in the second half of 2018, we began to raise cash for clients and aggressively so in December when the Fed showed it would not heed the warning from the credit markets and would continue to tighten its grip on financial markets. This helped to cushion some of the decline that year but what we did not anticipate was such an abrupt shift in monetary policy the other direction and why we were slow to deploy our clients cash back into the market.
Fast forward to this year, and we entered 2020 with a bullish leaning due to a green light given by the Fed to financial markets as its printing press was fast at work and we had a phase one trade deal with China, which helped to bring an end to the global economic downturn that began in late-2017 and ending in the fall of 2019. Over the course of 2019 and heading into 2020, we had moved clients from an underweight position in stocks relative to their benchmark to an equal weight position and, finally, in early 2020 we had moved to an overweight in stocks and other risk assets like commodities.
Just as U.S. markets ignored the stress in financial markets abroad in 2018, the S&P 500 initially ignored the impact COVID-19 was having on the rest of the world as it was being dominated by the influence of the technology sector. However, like 2018 we began to see cracks forming in U.S. markets and began to sell our most economically sensitive stocks like energy and industrials and started raising cash in February. Upon doing further research we were convinced the U.S. would not escape the fate that Europe and China had endured with lockdowns as our hospital system was not equipped to handle a massive influx of patients with flu-like symptoms. We aggressively raised cash beginning in late-February and into the first week of March, which allowed us to side-step the bulk of the crash that came later in the month. The market’s decline was the fastest bear market ever witnessed by the Dow Jones Industrial Average as it fell 20% in less time than the 1929 or 1987 market crashes.
The View from 30,000 Feet
Be fearful when others are greedy, and greedy when others are fearful.
– Warren Buffett
Buy when there is blood in the streets, even if the blood is your own.
– Baron Rothschild
In the early weeks of March when the markets were falling with an unrelenting decline, we stepped back to assess the situation and to plan a course of action with how to respond. Our view was that, just like authorities were quick to react to the 2018 mini-bear market, why would they not rush to the financial market and economy’s aid with the worst pandemic since the 1918 Spanish Flu? Further, we began to ask ourselves the question, “how many times has the Dow Jones Industrial Average fallen by more than 30% since 1900?” The answer: twelve times in over a century, or said differently, once every ten years. Indeed, the last time we had seen the Dow fall by more than 30% was the 2007-2009 financial crisis and we certainly were finding companies selling at or near their 2009 valuations. We further raised the question, “if we can’t buy stocks when the market is down over 30%, then when could we?”
Our writings in March reflected this shift in thinking as we looked at the value and bargains that were created during the decline as stated in our March 16th piece:
A Word on Today’s Volatility
The current decline in financial markets created the greatest valuation opportunity since 2009, particularly for yield-starved investors and retirees. With today’s drop, I analyzed all 500 stocks within the S&P 500 and looked at their dividend yields, price-to-earnings (PE) ratios, as well as their earnings yields (the inverse of the PE ratio), and I haven’t seen the market this cheap since 2009. For example, here are the total number of companies with various dividend yield levels:
# of Stocks Dividend Yield 1 >20% 6 10-20% 72 5-10% 111 3-5%
We had learned from our mistake in 2019 in which we were slow to put cash to work by beginning to scale into the market even before a bottom was in and not to try to time the market perfectly. As a recovery became clearer and the Fed moved to unleash money printing that made its 2008-2009 initial actions appear as chump change, we continued to put client capital to work as we moved away from a minimum-risk posture to a neutral stance on the market. Over the last few months, we have been adding to our exposure by taking clients to a slightly above-neutral risk level by increasing both our exposure to commodities as well as stocks.
As the markets have had a dramatic rise since March, some of our positions in client accounts had significant gains. Over the last month we began to divest a few positions that had erased the undervaluation we saw when we first bought them as we saw growing opportunities in other areas. One of the areas that has the greatest long-term appeal in our view is commodities.
A Generational Buying Opportunity in Commodities
Every now and then comes an extreme with which presents an opportunity to invest in deeply undervalued areas. One way to detect these extremes is by viewing where Americans invest their wealth, and when investors overly allocate to one asset class, other asset classes that had been ignored become attractively valued. An example of this concept can be seen by looking at American’s equity in real estate as a percentage of their financial assets. In the beginning of the last housing bubble, American’s equity in real estate made up roughly 20% of their financial assets and at the bubble peak in 2005, their equity had jumped 50% to represent over 30% of their financial assets.
After the bubble burst and American’s equity in real estate evaporated with the housing decline, homeowners equity in real estate plunged to a level never seen in the history of the data, ultimately declining to under 15% in 2012 (see green box on the far right below). With the benefit of hindsight, clearly 2012 was an attractive period to be accumulating real estate.
We walked through the example of real estate as an investment above to highlight what we are seeing in commodities and why it is one of our favorite asset classes. When we look at the value of commodities (using the S&P Goldman Sachs Commodity Index) to stocks (using the S&P 500) on a relative basis, we can see that over the last half century, at no point in time have commodities been this cheap relative to stocks. We are lower than the start of the 2000-2008 commodity cycle, and even lower than the early 1970s, which saw a highly inflationary environment in which both stocks and bonds performed poorly while commodities soared. Our belief is that with hindsight, the current period is likely to be an amazing investment opportunity in commodities, just as 2012 was for real estate.
Valuations are not a timing tool since what is cheap can get cheaper, and what is expensive can become even more expensive. What is needed is a catalyst and we now have over $6 trillion of them. In response to the COVID-19 outbreak we have seen the big four central banks (US Fed, ECB, Bank of Japan, Bank of England) expand their collective balance sheets by over $6 trillion, with trillions more in pledges. Never before have we seen global currencies debased on this scale in human history and when the supply of money is expanded out of thin air, tangible resources, which you can’t make out of digital ones and zeros or a printing press, historically increase in value, which is why we will continue to build exposure to this asset class.
Just as commodities have never been cheaper relative to stocks over the last half century, stocks are currently the most attractive to bonds than at any point in the last 50 years when viewed through income potential. Looking at the dividend yield of the S&P 500 compared to the 10-year US Treasury yield, stocks are as attractive relative to bonds as they were at the bottom of the Great Financial Crisis bear market of 2007-2009, and even more attractive than the tech bubble bear market that ended in 2003 as seen below.
The Business Cycle & Economic Risk
Our firm’s primary focus and style is a top-down approach, looking at the economic and investment landscape and then determining an asset allocation from those views compared to a bottoms-up approach which focuses one’s attention on individual company analysis to construct a portfolio. We adopt this approach because different asset classes have shown widely different returns depending on where we are in the four phases of the business cycle (early, mid, late, recession). As shown from Fidelity’s research, stocks have the strongest returns in the early and mid-part of the business cycle, significantly beating both bonds and cash. In the later portion of a business cycle, neither stocks, bonds, or cash have a significant edge over the other, though in recession stocks historically have suffered losses while bonds dramatically outperform both stocks and cash.
With this evidence in hand, our firm developed our own business cycle index to assist us in determining where the U.S. economy is in the four phases of the business cycle (shown below, recessions highlighted by red vertical bands). Over the last few years, we have held a relatively defensive allocation to stocks given our view that we were in the latter part of a business cycle.
However, with the deepest recession seen since the Great Depression induced by the COVID-19 pandemic, clearly we are no longer in the latter part of the business cycle and is why, since March, we have progressively increased our allocation to stocks and commodities by reducing our exposure to bonds and cash.
We have analyzed S&P 500 forward returns at each twenty point interval of our business cycle index and our data corroborates Fidelity’s in that stock returns are greatest at the early phase of the business cycle and lowest in late-cycle to recession. Our index currently sits at 44.50 and, as shown by the table below, forward returns for the S&P 500 when our index is between 40-60 show a positive 5.8% return 12 months out, 20.3% return 24 months out, and 33.7% return 36 months out.
We bring this up to explain our view that we believe we have started a new economic expansion and new bull market in stocks, and that we are in the early phase with which stock returns are the greatest. This is why we view any correction in stocks to be a buying opportunity to increase our exposure to stocks and commodities above our benchmark’s neutral allocation, rather than the start of a new bear market. With interest rates back at zero and likely to stay there for years to come, cash and bonds in our view have poor long-term return characteristics.
We do believe that between now and immediately following the election there is likely to be greater market volatility than we’ve witnessed over the last few months, and we will go into detail our thoughts on election-risk, COVID-19 resurgence risk, as well as many other near-term topics. Before going into the near-term picture, however we felt it was important to begin with the view from 30,000 feet which provides context with how we view the near-term outlook.
There were many sharp corrections in the early years following the 2009 bottom in stocks, but the bull market remained intact and those corrections proved to be buying opportunities. We are in the middle of a correction now and we believe there will be more heading into 2021, but ultimately believe these remain buying opportunities until proven otherwise.
Please be on the lookout for a future article in which we highlight near-term risks. If you have any questions, please do not hesitate to reach out to your wealth manager.
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Copyright © 2020 Chris Puplava