May 18, 2020
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Capital markets look like they’re in the eye of a storm recently, with a period of calm after what was one of the most volatile periods in global market history. Does it get better from here, or is this a big fake-out for another round of selling as we move deeper into this year?
What happened in the first quarter was mainly a liquidity storm, and the deeper into this year we get, the more solvency becomes the key issue to be concerned about.
As the economic machine and its associated incomes came to a halt in Q1 of this year, the liquidity storm consisted of countless companies drawing on their revolving credit facilities from banks at the same time to get cash on their balance sheets (a corporate version of a bank run), the foreign sector scrambling for dollars to service dollar-denominated debts (and selling some of their U.S. Treasury reserves to get them), tens of millions of people losing their jobs in the United States and countless more losing jobs internationally, and virtually all markets (Treasuries, credit securities, equities, oil futures, precious metals futures) becoming very illiquid as sellers overwhelmed buyers.
Then, the unprecedented magnitude of fiscal and monetary policy response to this liquidity crisis flooded global markets with liquidity. As part of over $2.7 trillion in crisis aid from Congress, helicopter money checks were sent out to most American households, extra unemployment benefits were provided, small businesses received loans that can turn into grants (although that was one of the logistically problematic programs), funds were provided to various portions of the health care system, and bailouts were offered to certain industries. The Federal Reserve funded those fiscal programs by creating dollars ex nihilo and buying record amounts of Treasury securities with those new dollars, and they also bought mortgage-backed securities and set up a special purpose vehicle backed by the Treasury Department and allocations from Congress to buy corporate bonds and municipal bonds with loss protection. In addition, the Federal Reserve set up liquidity swaps with foreign central banks to provide dollars in exchange for foreign currency, which is an attempt to alleviate the global dollar shortage and prevent further foreign sector sales of Treasury securities.
This chart perhaps best sums up the economic shock. It’s the nonfarm payroll number, which shows the 20 million jobs that were lost in April alone:
Chart Source: St. Louis Fed
With initial jobless claims still rolling in weekly by the millions (roughly 36 million in total so far), May is likely to see a deeper figure. After that, we’ll see.
On the other hand, here’s a chart that captures the liquidity response:
Chart Source: St. Louis Fed
The Federal Reserve increased their balance sheet by almost $3 trillion within a couple months, which is already larger in magnitude in both absolute terms and as a percentage of GDP, than their immediate response during the 2008 crisis. In essence, they “print money digitally” to buy assets such as Treasuries and mortgage-backed securities, and to provide other central banks with currency swaps. Over half of that balance sheet increase involved buying Treasuries to fund the government’s aforementioned fiscal response, and it’s probably going a lot higher by the end of the year.
Some bankruptcies have already occurred, including well-known companies like Gold’s Gym and JCPenney. This is the beginning of the solvency portion of the crisis. Some companies, even if they can get access to money at the moment (liquidity), simply have too much debt and a structurally noncompetitive business model (solvency), and need to either liquidate or restructure. The next several years are likely to be challenging for many companies with weak balance sheets, so make sure you know what you own.
The Divergence
A big topic in the financial media, or at least in the more critical or alternative financial media, has been the huge divergence between the stock market and the real economy.
This screenshot from CNBC made the social media rounds last month and expresses that divergence well:
Source: CNBC
Even as people continue to lose jobs and total employment continues to decline, the stock market bottomed in March and has rebounded very strongly since then. So we have what appears to be a divergence between Wall Street and Main Street. If that is the case, this has all sorts of implications.
A potential financial implication is what many equity bears have suggested: that this rally in stocks has been mostly an illusion and is destined to fall back down to economic reality. Recessions and bear markets generally have many strong rallies within them even as they eventually fall back into lower lows before eventually finding a bottom.
A potential political implication involves the perception that policymakers bailed out Wall Street more than Main Street and further contributed to increasing wealth concentration and crony capitalism. With $2.7 trillion in crisis funding signed into law so far, that’s about $8,000 per capita or $21,000 per household, but how much aid has the median American on Main Street really received, directly or indirectly?
If we look back over the past three recessions, we actually see similar market behavior. It’s just that the magnitude and time compression of this job loss was so unprecedented.
If we compare the Wilshire 5000 index (which represents virtually all of the U.S. stock market) to the 4-week moving average of initial jobless claims, the past three recessions show that the market tends to bottom roughly when initial claims hit their peak:
Chart Source: St. Louis Fed
In the early 1990’s recession, the market bottomed slightly before initial jobless claims peaked. In the early 2000’s recession, which was really more of an equity bubble with a very long stock market decline, the market bottomed a bit after initial jobless claims peaked. In the 2008/2009 recession, the market bottomed slightly before initial claims peaked.
We don’t know if the March 23 stock market low was “the bottom” or just “a bottom”. But if it happens to have been “the bottom”, it occurred right before initial jobless claims peaked, just like in 2 of the past 3 recessions:
Chart Source: St. Louis Fed
Initial jobless claims reached almost 7 million at their worst point when the quarantine began, and the 4-week moving average reached nearly 6 million. That rate has now slowed to under 3 million lost jobs per week, which means that the total number of job losses continues to grow, but at a slower weekly pace than before.
Chart Source: St. Louis Fed
In other words, the market doesn’t historically tend to bottom at the lowest point in total job losses and rebound when jobs start to come back. Instead, it tends to bottom closer to the highest rate-of-change period of job losses, which comes earlier. When those job losses are still coming in but at a slower pace, the stock market starts to see the light at the end of the tunnel, hopes that the light isn’t an oncoming train, and starts working its way up on higher sentiment, usually with a ton of help from fiscal and monetary responses that throw money at the problem.
That doesn’t necessarily make me a broad equity bull at the current time, though. This was a massive rally off the lows and has already started to trend sideways. Even if March 23 was “the bottom” for this cycle, there’s a good probability that the equity market will grind around for a while, up and down. Market performance can be bad in real terms, over a near-term or long-term period of time, whether or not it makes lower lows. It can chop around for a while, go higher or lower within a wide range, and to what extent it does will likely depend on how much money that policymakers flood the system with to mitigate ongoing liquidity and solvency problems, as well as depending on investor sentiment.
Record S&P 500 Concentration
If we dig a little deeper, we can see that most of the stock market actually still does look like the real economy: down big and with little improvement yet.
The top five stocks in the S&P 500 (Microsoft, Apple, Amazon, Alphabet, and Facebook) now make up over 20% of the index, which surpasses the amount of concentration that occurred even at the height of the Dotcom bubble:
Source: Goldman Sachs, via Business Insider
We have to look back to the 1980’s and 1970’s to find more concentration in the U.S. stock market than we have today. Back then, AT&T and IBM dominated the index, and the overall market was much smaller, so it was easier for companies to dominate it. AT&T was broken up, and IBM went on to gradually diminish in relative importance.
There were times when Exxon Mobile and General Electric had the biggest spot in the S&P 500 as well, in the 1990’s and 2000’s. The future could always be different, but historically, being the top stock in the index has generally led to poor performance over the next 5-10 years relative to the rest of the index.
If we look at several indices’ performance year-to-date (represented below by ETFs), we see that most of them other than the Nasdaq 100 and S&P 500 actually do look more like the economy:
The Nasdaq 100 (QQQ) is up the most, as the top five stocks account for over 40% of that index.
The S&P 500 (SPY) is next in terms of performance, since the same top five account for over 20% of that index.
The equal-weight S&P 500 (RSP), which has the same 500 companies but is weighted equally rather than weighted in terms of market capitalization, is far behind them. In fact, emerging markets (EEM), foreign developed markets (EFA), and the equal weight S&P 500 (RSP), all have about the same performance this year.
Behind them are mid-cap stocks (MDY) and small cap value stocks (SLYV), which have dramatically underperformed. Certain sectors, such as the financial sector, have also deeply underperformed.
So, most stock market indices actually do look quite a bit like the real economy, with a big fall and little recovery. However, the top 5 mega-cap stocks have held up the major American stock market indices like Atlas holding up the world, and reached levels of concentration not seen in nearly four decades.
It’s notable that this has not been the case internationally. MSCI equal-weighted international indices (whether it’s emerging markets, or the full all-country ex-USA index) have performed about the same as their market-cap weighted versions year-to-date as of the end of April.
So, this has not really been a case of a performance differential between U.S. stocks vs international stocks broadly. It has been a case of the top five U.S. stocks outperforming just about everything else, including the rest of the American stock market.
Fundamentals or Valuation?
This U.S. mega-cap stock market concentration is partly from fundamentals. For example, Amazon has of course had a far better time than most physical retailers in this quarantine environment, so the performance gap between itself and them has widened even more.
However, valuation is also a big factor. Many stocks are rightfully trading at historically moderate-to-low valuations, pricing in the high probability of substantial economic pain ahead. However, investors have flocked into these tech titan stocks in search of strong balance sheets and seemingly quarantine-resistant business models, almost at any price.
Apple stock, for example, isn’t this high purely on bigger fundamentals; it also received a valuation premium by the market over what were rather flat fundamentals in recent years, and hasn’t really lost any of its high valuation this year:
Chart Source: F.A.S.T. Graphs
Each valuation metric has its pros and cons. This chart shows that Apple is more expensive than its 5-year average in terms of price-to-sales, price-to-book, and dividend yield:
And we can look at the “P/E 5” ratio, which divides the current price of a stock by the average of the past five years of real earnings and gives us a nice snapshot for how the price is relatively to a smoothed baseline of earnings. By that metric, Apple is also quite expensive relative to its average. I added the EV/EBITDA ratio on that chart as well:
With geopolitical tensions increasing between China and the United States again, Apple has risks related to Chinese supply chain issues and access to the large Chinese consumer market. It also has general risks related to people not upgrading their premium-priced phones as frequently due to being tight on cash. The iPhone market is quite saturated, so the company is increasingly reliant on services and accessories to further monetize its existing user base.
Apple has plenty of cash, but whether it’s a good buy becomes a matter of growth and valuation. Hypothetically, if the company does absolutely fine fundamentally, but the valuation merely falls to its 5-year average, it could have a 30% price cut down to $200/share and frankly, nothing would be unusual about that. Or maybe it won’t, and the valuation averages will gradually catch up to where they are now for Apple. A lot of it depends on investor sentiment.
I’m not looking to single Apple out here, and am instead just trying to point out some of the valuation risks among some of the mega-caps that, if they were to turn down, would broadly affect the S&P 500.
Portfolio Updates
I have several investment accounts, and I provide updates on my asset allocation and investment selections in each newsletter issue every six weeks.
These portfolios include a primary passive/indexed retirement account, two actively-managed brokerage accounts at Fidelity and Charles Schwab, and the model portfolio account specifically for this newsletter at M1 Finance that I started last year.
I use a free account at Personal Capital to easily keep track of all my accounts and monitor my net worth.
M1 Finance Newsletter Portfolio
I started this account in September 2018 with $10k of new capital, and I put new money in regularly. Currently I put in $1,000 per month.
It’s one of my smallest accounts, but the goal is for the portfolio to be accessible and to show newsletter readers my best representation of where I think value is in the market. It’s a low-turnover multi-asset globally diversified portfolio that focuses on liquid investments and is scalable to virtually any size.
I chose M1 Finance because their platform is commission-free and allows for a combo of ETF and individual stock selection with automatic and/or manual rebalancing. It makes for a great model portfolio with high flexibility, and it’s the investment platform I recommend to most people. (See my disclosure policy here regarding my affiliation with M1.)
And here’s the breakdown of the holdings in those slices:
Changes since the previous issue:
- None
Although I made a number of small changes in March (cutting a few stocks that were particularly exposed to permanent capital loss, and adding to others, and tweaking the asset allocation overall), I haven’t made any changes since the late-March newsletter.
With my next contribution around the end of May, if the market remains as rallied as it is now, I may increase Treasury exposure.
Performance Review
The last performance update was in September 2019, so it’s time for another checkup.
Since the M1 portfolio consists of stocks and bonds and is geographically diversified with low turnover, my main comparison benchmark is a 2050 target date retirement fund called the “2050 Lifecycle Fund” hosted by the Thrift Savings Plan, which is what military and federal civilian employees have access to and invests in a set of broad index funds. It includes U.S. stocks, foreign stocks, and bonds. I write a weekly column for the TSP and they have good daily data including dividend reinvestment, so it’s a benchmark I like to use.
I can also compare the performance to the higher-risk pure S&P 500 total return index, and I threw the foreign developed market total return index (MSCI EAFE) on the chart as well.
The performance gains calculation is based on dollar-cost averaging from inception through the end of April 2020. I track what days I put money into the account, and the three benchmarks on the chart represent the performance if I had put the same amounts of money into those other index funds on the same days. So, the portfolio and the benchmarks all include the same magnitude and timing of dollar-cost averaging.
This chart shows the total gains or losses of the portfolio compared to those other index funds, from the baseline of how much money was dollar-cost averaged into them (which totaled $25,000 so far):
The M1 portfolio has outperformed the 2050 target date fund by $673.23, or 270 basis points compared to the total capital put in. It greatly outperformed international developed stocks, but is slightly behind a 100% pure S&P 500 portfolio, albeit with less volatility (way less volatility during the Q4 2018 sell-off, but only a bit less volatility during the Q1 2020 sell-off).
There are three main asset allocation decisions that have affected its performance compared to the benchmark target-date fund; two in favor and one against, which overall have contributed to mild outperformance vs the diversified target date fund so far.
Performance factor 1) Gold and Gold Stocks
Unlike many portfolios that only consist of stocks and bonds, the portfolio includes precious metals as part of its mix.
Specifically, the portfolio added gold and silver, and some precious metals stocks (royalty companies and miners) starting in October 2018, and they have been among the best performers in the portfolio since then, represented here via popular gold and gold miner ETFs:
Because the portfolio dollar-cost averages into the mix, it kept buying gold and gold stocks at both relative highs and big dips along the way, and overall this decision has been a big beneficial force in the portfolio. It particularly helped lower downside volatility during the market decline in Q4 2018. It didn’t help much during the Q1 2020 crash, but did help the portfolio recover more quickly in Q2 2020 from that crash so far, as gold stocks have broken out to seven-year highs.
Performance factor 2) Counter-Cycle Approach
The portfolio has used a counter-cyclical Treasury management policy, which benefited it as well. During the market peak before the COVID-19 crash, the portfolio had 19% exposure to Treasuries, and during the crash, it sold some Treasuries to buy equities and precious metals, which were selling off. At the current time, the portfolio is down to 8% Treasuries, but with my next monthly contribution I may increase that again.
My separate retirement account used a similar approach, but with 40% Treasuries and other safe bonds pre-crash (which is quite a lot for someone my age), which during the crash was brought down to 29%.
Performance factor 3) Mega-Cap Concentration
A factor that has detracted from performance has been the major concentration of the top five stocks in the S&P 500 (and about a dozen other ones in there, mostly software-related) vs almost everything else. Although the M1 portfolio outperformed an equal-weight version of the S&P 500 by quite a bit, for example, the momentum-based market-cap weighted S&P 500 has performed exceptionally well in this environment due to increasing concentration in the mega-cap names.
Not having a full 20% or more exposure to those mega-cap stocks has been a relative headwind. The M1 portfolio has included Microsoft and Alphabet for most of its history and still owns them, although not at the very high 3-6% concentrations that they have in the S&P 500. The portfolio also held Apple for about a year with a big gain, but eventually sold when it went over $250/share, and never held it to the same level of concentration as the S&P 500. The portfolio has not had Amazon or Facebook. Any exposure in the portfolio to small stocks, international stocks, many medium-sized stocks, and REITs, has been a headwind relative to the S&P 500, although dollar-cost averaging has mitigated that headwind to some extent.
In the months and years ahead, this is a key question for investors to answer for themselves. Will the concentration continue to increase, with the handful of mega-cap stocks getting even more expensive and other stocks getting even cheaper (thus continuing to provide a headwind against most diversified portfolios), or will there be some degree of mean reversion between beaten-down stocks and the expensive mega-caps (and thus provide a tailwind to most diversified portfolios)? Historically over decades, the equal-weight S&P 500 outperforms the market-cap-weight S&P 500, although over the past five years and particularly the past year, that hasn’t been the case.
In my view, the probability is towards mean reversion, but the timing is more questionable. A likely catalyst for such a trend change, in my view, would be a shift from the current disinflationary trend to a more reflationary trend based on larger and larger monetary and fiscal responses to the current unemployment crisis as we move later into 2020 and 2021.
Primary Retirement Portfolio
This next portfolio is my largest. It purely consists of index funds that automatically rebalance themselves regularly, and I rarely make changes.
Here’s the allocation today:
From 2010 through 2016, this account was aggressively positioned with 90% in equities and enjoyed the long bull market.
Starting in 2017, in order to preserve capital, I dialed my equity allocation down to 60% (40% domestic, 20% foreign) and increased allocations to short-term bonds and cash to 40%. This was due to higher stock valuations and being later in the market cycle more generally.
After equities took a big hit in Q1 2020, I shifted some of the bonds back to equities, and it is now 71% equities (46% domestic, 25% foreign), and short-term bonds and cash is now down to 29%. For my TSP readers, this is equivalent to the 2040 Lifecycle Fund.
Related Guide: Tactical Asset Allocation
This is an example of a portfolio strategy that takes a rather hands-off approach but that still makes a tactical adjustment every few years if needed, based on market conditions, which reduces volatility and makes the retirement account feel less like a casino than many indices these days.
This employer-based retirement account is limited to a very small number of funds to invest in, so my flexibility is limited compared to my other accounts. I would, for example, have 10%+ precious metal exposure in this one in place of some of the stocks and bonds if I had that option.
Active Portfolios
My accounts at Fidelity and Schwab are mainly for positions in individual stocks, single-country ETFs, and selling options, and helps to fill some of the gaps that my index retirement account has.
Changes since the previous issue:
- Bought Bitcoin.
In April, I purchased some bitcoins at a cost basis of a little over $6,800 per bitcoin with an intended holding period of perhaps 2-3 years. As of this writing, it’s over $9,500 per bitcoin, although it’s a very volatile asset and can change quickly. It’s not in my brokerage accounts, but I include it here as a financial holding.
I’ve been neutral on Bitcoin for years but in April I became bullish on it as a small holding due to the amount of central bank liquidity that will likely continue to come for the next several years. If it dips below $8,000 again, I may add another tranche of exposure.
As a coin collector, I also invest significantly in physical bullion, accumulated over the past 2 years: gold, silver, and a bit of platinum. I sold my previous coin collection in 2011, and started my current one in 2018, which is another example of a counter-cyclical investment approach. For now, I am merely holding my existing collection because physical coins have been hard to get without paying an extremely large premium over the spot price.
Global Opportunities 2020 Report
It’s that time of year again.
I publish an annual Global Opportunities report that analyzes over 30 countries from around the world. This includes equity valuations, currency analysis, debt levels, trade issues, and other factors that are likely to impact the risk-adjusted long-term return potential of different equity markets and currencies around the world.
The 2020 version is now available. Members of the premium research service can access it for free as part of their subscription in the members area.
If you’d prefer to purchase it separately as a non-member, you can do so here. It is currently available for $14.95 for early readers, but by the end of Wednesday it will go to its full price of $19.95.
If you want a macro backdrop for international equity allocation within a portfolio, or for currency trading, it’s a useful set of research. Even if you just want to understand more of the global financial picture in general, it provides a very high-level view that lets you quickly see how different countries are doing from a structural point of view, including where their strengths and weaknesses are.
In last year’s April 2019 report, two countries tied with the highest overall score, and three countries tied with the overall lowest score. Although the report is not geared towards 1-year returns and COVID-19 made most equity returns poor over the past year, the average of the top 2 countries outperformed the average of the bottom 3 countries by almost 800 basis points since publication.
There was a more consistent difference in outcomes between high-ranked currencies and low-ranked currencies in the report. Two countries, Argentina and Turkey, were tied as having the worst currency score in the April 2019 report, and they are both down very significantly (down over -30% and over -15% respectively vs the dollar) since then. Five currencies including the Swiss franc, Thai baht, Singapore dollar, Russian ruble, and pegged Hong Kong dollar, were tied as having the highest currency rating, and four out of those five ended up being quite strong (staying relatively close to the dollar from -4% to +5%). The worst-performer of those high-ranked currencies (the ruble) held strong all year until the recent oil price crash, but even then it has outperformed the worst-ranked currencies.
If you want to see how different countries compare on multiple metrics, check it out, either individually or via a premium subscription.
Final Thoughts
Going forward, I continue to like precious metals within a portfolio mix, but am also strongly interested in beaten-down stocks that specifically have strong balance sheets.
I’m not interested in beaten-down highly-indebted businesses, because they are likely to face ongoing solvency issues. However, high-quality companies in the U.S. and internationally with a) strong balance sheets and b) that happen to operate in cyclical industries but have good long-term prospects, is specifically the subset of companies that may have a lot of potential over the long run from current levels.
At this point, investors would do well to consider the meaning of the morbid phrase, “you don’t have to outrun the bear, you just have to outrun your friend.” This hypothetical scenario refers to a bunch of human campers trying to outrun a hungry bear that is chasing them (and which is faster than humans, but can’t catch all of them).
In other words, policymakers around the world can’t afford to let a massive deflationary economic collapse occur, and for millions and millions of people to be unable to afford the necessities of life and for half of large companies to go out of business, so they will be forced to keep the stimulus taps open, funded with printed money, with a willingness to devalue currency to avoid the worst case economic scenario. Cheap stocks that survive and go on to rebound, are likely an opportune set of investments.
That doesn’t mean that the large stock indices won’t go down; in fact I think they’ve come too far too fast and could use a reality check. And it certainly doesn’t mean every company is safe; many of the weaker ones with a lot of leverage are dead weight and I wouldn’t touch them.
But a sweet spot in my view is companies that have recently become cheap and that will have a tough 2020 and 2021, but have among the strongest balance sheets in their industry and structurally strong business models in a post-virus scenario. If we start with the premise that, say, the whole steel industry won’t go bankrupt, or the whole automotive industry, or the whole multifamily housing industry, or the whole banking industry, and so forth (especially all at once in a mass collapse), then the question becomes, “which players are the strongest in their industries, the best-positioned to outlast their peers and make it through to the next reflationary cycle?” That’s where I am looking and buying for some of my risk exposure.
Best regards,
