What a long, strange trip it’s been… and it is only July. The equity markets were mixed through the end of the second quarter 2020. The Dow Jones Industrial Average lost 9.6% year-to-date, the Standard and Poor’s 500 Index was down 4.0% and the Nasdaq Composite surged 12.1% on the back of a few out-performing, large cap tech stocks. Equity performance for the second quarter was very positive, with the DJIA gaining 16.6%, the S&P surging 18.9% and the Nasdaq soaring 29.6%. This remarkable bounce came following the dismal first quarter. Recall, if you can stomach it, that in the first quarter, the DJIA fell 23.2%, the S&P dropped 20.0% and the Nasdaq Composite erased 14.2%. Following the close of the quarter, the equity markets continued to improve, albeit in an uneven fashion. Large capitalization tech stocks drove the Nasdaq’s large gain, while the S&P finally saw a year-to-date breakeven and the DJIA sat on a 6.5% loss from December 31st levels. Money is surging into both small cap “story stocks” and large cap tech names, and the result is a bit discombobulating to us. On the date of this letter, Microsoft, Amazon and Tesla shares gained 4.3%, 7.9% and 9.5%, respectively… on no substantive news. That does not reflect a normally functioning market.
Two things seem to be driving the flood into momentum stocks. First, with interest rates slammed to historic lows by hyperactive central bank coordination, there are not many obvious alternatives for investment other than equities, and especially equities that can thrive in a stunted “three-quarters” economy. Treasuries used to offer riskless return at higher interest rates. Now, unless the economy tanks further, they offer return-less risk. Price discovery is crippled when central banks dictate interest rates, and so institutional investors are throwing in the towel on appropriate credit spreads, and increasing risk exposures. This is a self-reinforcing cycle… until it isn’t. More traditional dividend-paying stocks, which we prefer, have more exposure to current recessionary conditions and more modest valuations than the favored big tech names. We like their chances in a recovery. The other driver seems to be some level of FOMO, or “fear of missing out.” There is nothing more unsettling than watching your idiot nephew successfully day-trade stocks he knows nothing about. We know. We have seen it before. It doesn’t end well, but it is still hard to resist. We are reminded of something Charlie Munger said: “Envy is a really stupid sin because it’s the only one you could never possibly have any fun at.”
The debt issued to fight the pandemic will restrain economic growth over a long period. The IMF estimates that the world’s twenty richest countries have earmarked 3.5% of their GDPs to the pandemic crisis, more than they spent at the nadir of the Great Financial Crisis. It further estimates that gross fiscal debt in advanced economies will expand 16% this year, to 122% of GDP. Central banks have enacted measures to keep the cost of debt low. The U.S. Treasury yield curve is barely visible, with short-term rates at close to zero, and longer-term rates in the “why bother” range. The 2-year now yields 0.15% versus the 0.65% yield of the 10-year note. At the beginning of 2016, the 2-year paid 1.02% and the 10-year yielded 2.24%. Looking at international rates, the picture is the same. The ten-year notes in Germany, Italy, Spain, the U.K. and Japan yield -0.46%, 1.08%, 0.35%, 0.16% and 0.02%, respectively. The Federal Reserve is entertaining yield curve control, or the targeting of certain debt maturities to influence market interest rates. This is similar to what was done by the Fed following WWII, to allow the country to grow into its debt levels at a “comfortable pace”. Although, the scale of the effort is larger now and the path for American growth is not as clear.
The U.S. budget deficit touched $3.0 trillion in the twelve months ending in June. Tax receipts plummeted and stimulus spending soared. As a percentage of GDP, the 12-month deficit reached 14%, eclipsing the 10% deficit seen during the Great Financial Crisis. Federal spending in the first nine months of fiscal 2020 topped $5.0 trillion, and outlays grew 49% over the year-ago period. The CBO (Congressional Budget Office) reported that unemployment payments of $277 billion increased over 1,000% over last year’s $24 billion. The Paycheck Protection Program distributed $537 billion to support employment. The nine-month deficit was $2.75 trillion. This is obviously grossly unsustainable. Except in an election year. Republicans are crafting an additional stimulus plan said to cost about $1.0 trillion. House Democrats have already passed a $3.0 trillion stimulus bill. Some combination of these two bills will most certainly become law. U.S. Federal debt already exceeds GDP. When interest rates are at more normal levels, it will take all of the economy’s nominal growth just to service the interest costs of that debt level. This means that standards of living will decline or stagnate, and productive government programs will not be funded. Young Americans will be paying for the COVID-19 stimulus for many years.
Stock indices are near the levels they reached before the COVID-19 pandemic. The world is in worse shape, however. It is time to be conservative, and not time to chase gains. Realistic goals and disciplined portfolio allocations will always be rewarded…eventually. If you get that FOMO feeling, remember what George Carlin said: “Think about how stupid the average American is. Now consider that half of the population is dumber than he is.” Play your game, not his.
Your Team at Baxter Investment Management