Dear Clients and Friends,
Three months have passed since our last newsletter and the Coronavirus is still with us. For better or worse, people have adapted somewhat to the new reality. It does not make it less tragic, but a perennial state of crisis is not a preferred way to live. It is also quite remarkable how adaptable people are, giving credence to the expression “necessity is the mother of invention.” Folks have taken to working from home, moving professional and social lives to a virtual setting, and figuring out how to navigate the six feet exclusionary zone, for the most part.
This adaptive coping is not entirely unrelated to the relentless recovery in the stock market. Be that as it may, it still begs the question: why is the stock market going up when the economy is going down? If you haven’t seen that headline before, you read it here first. It is always possible to create a narrative to explain what happens in the stock market, after the fact. That narrative now holds that massive fiscal stimulus from Congress and monetary intervention from the Fed have put a bottom under stock prices. Furthermore, there will be a vaccine at some point and while things are bad, they are going to get better. In fact, if the market is to be believed, they will get better soon and fast, in other words, we will see a V-shaped recovery.
And the market is never wrong. I say that with only a mild dose of sarcasm. In a technical sense, the market is perhaps never wrong: it merely reflects the opinions and mood of investors in the aggregate. And that mood is optimistic, judging from the ferocity with which market indices have roared back up the cliff they fell off last quarter. But looks can be deceiving. On closer examination, the S&P 5 – the 5 biggest stocks in the S&P 500 index – is up 35% while the S&P 495 – the other 495 stocks – is still down year-to-date.
What to make of this discrepancy? At some level, it is telling us that the optimism for a rapid recovery is actually more fragile than it looks on the surface. Investors are only willing to dive into big tech names, but if a sustained recovery were truly to take hold, they should also feel comfortable holding cyclical stocks (those sensitive to the economic recovery). Yet they do not. It also tells us that FOMO (fear of missing out) is alive and well. Amazon and Tesla, for example, are darlings and it hurts to miss out. If you invest on the basis that something is popular and do not care about the price you pay for the profits of the underlying investment, you rely on that popularity to last so that those who buy in after you, are willing to pay an even higher price.
This can go well for a while, but when do you get out and how do you know that you did not get in too late? The problem is that eventually the shiny carriage might turn into a pumpkin, but unlike Cinderella, no one knows at what time that will happen.
Speaking of FOMO, let us segue to the Stay-At-Home Trade, another trait of today’s market. In a nutshell, there are certain companies that benefit from SIP (shelter-in-place), and WFH (work-from-home) and their stocks are coveted. It is easy to convince oneself: everybody is on Zoom, everybody orders more from Amazon, more people watch more Netflix. What a great idea it would be to buy stock in these companies; a slam dunk road to riches. To be sure, it is not useless to try to figure out which companies are well positioned for the current and post-pandemic world. However, if everybody comes to the same investment decision, it is unlikely that following through on that decision will lead to high future returns.
In addition to the Stay-At-Home Trade, there is the Stay-At-Home Trader. It takes about a generation to forget about the excesses of a speculative bubble and go for broke again. It is now two decades since the dotcom bust. While the 2008 Great Recession was also a bust, retail investors weren’t as widely engaged in the stock market that time around, still licking their wounds from 2000. Fueled by free stock trading and new platforms like Robinhood, speculative fury is reaching a fever pitch. With many stock market participants working from home, or otherwise at home and the year 2000 a distant memory, if a memory at all, and sports absent from TV, the conditions are primed for speculation in the stock market. So far, many day traders have not done so poorly, jumping into beaten up stocks near lows, even bankrupt ones like Hertz and riding popular stocks to new heights. I hope it ends well, but it is unlikely.
Where do we go from here
In April, with the benefit of hindsight, risk was to the upside. Meaning that if you moved to the sidelines then, you missed out on a once-in-a-generation stock market rally. Today, risk seems more to the downside, in my opinion: the risk of a substantial drop in equity markets seems greater than a continued “melt-up.” I say that because the V-shaped recovery is not a foregone conclusion, yet the stock market seems to take that view. Of course, both can happen. For most of our clients we are running their portfolio risk levels somewhat below their long-term targets. If a sell off materializes, that allows us to be opportunistic as we will have room to increase risk levels. We are also weary to make big moves now, there is just so much uncertainty that the main goal ought to be to live to fight another day.
Green stocks rise to the fore
There are 11 sectors in the S&P 500 Index. Green stocks are not their own sector, but if they were, they would rank 2nd in performance. I am using the Cleantech Index® as a proxy for the green stock sector. I specifically chose that index, because it does not have Tesla in it, so as not to skew the returns in favor of the green sector. That index also has some international stocks in it, so not apples-to-apples in that sense, but that does not make the comparison less impressive, given that international stocks have lagged the US market.
One explanation I have heard for the strong performance of green stocks is the increased likelihood of a Biden presidency. Biden’s “100% green grid by 2035” bid, certainly will be a tailwind, all things equal. But all things are never equal. During the Obama administration there was strong support for clean energy and low carbon investments, but that did not translate into good returns for the stocks in those sectors, in the aggregate. In fact the Obama era was terrible for green stocks (not his fault, btw).
However, I think a supportive administration is going to be more accretive to stock performance this time around, because the sector has matured and the companies in it are more disciplined in terms of profitability-over-growth. They also have more scale, are more competitive with the high carbon economy, and have a broader appeal among investors.
Let me sign off there. August is calling me, as I imagine it is calling you. I hope the summer months are bringing relaxation and a much needed chance to recharge the batteries. We all need it.
Jan Schalkwijk, CFA
JPS Global Investments