Double Top, or Not? Much of the recent resilience in the US Equity market has come from the top five holdings (representing 46% of the Nasdaq and 21% of the S&P 500). With an initial “V” shaped recovery first showing in markets, positive beats in US economic news have followed. The focus now turns to whether these stocks will continue to lead the economy higher or whether a downturn or break in uptrend may signal an inflection point to the Covid recovery.
While magazine covers have a checkered history of foretelling turning points (more often than not contrary to their headlines), they do reflect sentiment of investors and provide a caption for market beliefs. To the first point, it was not a positive to see Jeff Bezos front and center on this week’s cover of The Economist.
Competing Narratives. Nobel Prize winning Economist Robert Shiller gave a presentation this week on the topic of his most recent research topic of Narrative Economics. Unlike the traditional “rational” approach to economics where facts influence feelings, Shiller argues that economic facts become realities based on collective feelings and shared stories. How could that impact investing today and what competing narratives exist? I would summarize things this way:
“With cash earning nothing and safe bond yields below the rate of inflation "There Is No Alternative (TINA)" and stocks and other risk assets provide the only remaining opportunity for real growth. The Fed will do “whatever it takes” to bail out the market with easy money and to the extent required, asset purchases.”
Vs.
“The Fed has created an "everything bubble" by using its influence and balance sheet to overpower the market's function of price discovery. Markets are now driven by speculative buyers and stock prices are unhinged from fundamentals. Ironically, the market is discounting a new expansion in the economy at the same time a major recession has only just begun.”
More Room to go. To explore the first narrative in further detail, let’s consider the positives. Admittedly, this is more challenging for me to do currently, as a primary driver rests on asset prices themselves. Stocks have experienced a buying stampede of sorts recently, triggering what market participants refer to as “Breakaway Momentum.” On top of this momentum (generally not seen this far into a market advance), markets are indeed being supported by the Fed’s surge of liquidity, with money supply (M2) rising and at elevated levels (see detail from Tom McClellan). Even with $2.4T of legislation passed, more is likely to come as the White House reported this week the Trump administration wants a $1T infrastructure proposal as part of its next initiative to deal with the Covid recession. This comes at a time when US capital spending is desperately needed, given the record age of US infrastructure. Though the near-term earnings picture is admittedly bleak, one positive stand out is that current estimates for remaining quarters in 2020 and 2021 have stabilized.
Contemplating Bubbles. While there is ample evidence that “Stocks for the Long Run” provides a sound foundation for long-term investing, stocks can and do experience periods, sometimes years, of underperformance. The worst of times have been characterized by bubbles- excesses that, after being built up in the financial system, wreck portfolios and the future spending goals and aspirations tied to them. Noted investor Jeremy Grantham, famous for calling the three prior bubble periods (Japan, Nasdaq and Housing) has labeled Covid as such, “this one is the real McCoy, this is crazy stuff.” Mr. Grantham made this point in his quarterly letter, “The current P/E on the U.S. market is in the top 10% of its history. The U.S. economy in contrast is in its worst 10%, perhaps even the worst 1%. This is apparently one of the most impressive mismatches in history.”
The Two Errors. To tie things together, the above scenarios may not be mutually exclusive in the near term. In other words, we may have more to go, yet find we were in a bubble down the road with the benefit of hindsight. As the late Jack Bogle once said, “in the stock market, anything can happen.” Therefore investors, particularly those who are close to or transitioning into retirement, should be prepared for all outcomes. Howard Marks refers to this as balancing between two errors: losing opportunity or losing capital. These two errors are directly linked to one another such that decreasing one automatically increases exposure to the other. Therefore, an investor’s primary job is to balance between the two and determine which error is the most prudent to minimize.
When planning for retirement, these same errors can be brought over and directly applied to spending goals. Is the primary objective to “protect the floor” (guard against adverse market losses to ensure a minimum funded retirement) or is it to “reach for more” (expose the portfolio to more upside in order to grow future spending potential)? Answering those questions, along with your current assessment of the risks and potential opportunities, should influence your current asset allocation.
I will close here for the week. Have a great weekend.