We are not believers in the permanently changed world view as it relates to the coronavirus. It is amazing how about the weirdest six months in U.S. history continues to be extrapolated in markets often by new traders using immense amounts of call options that expire in a week or less. Meanwhile, the credit cycle is playing out behind the scenes, but it might soon become front page news as delinquencies and defaults escalate in a bifurcated economy.
The view being expressed in stocks is that we will forever be stuck in a newly furnished suburban home (that we just bought and stuffed with things from Home Depot) sporting brand new Nikes while riding our Pelotons and conducting Zoom meetings and gambling on DraftKings using a new PC while waiting for UPS and FedEx to deliver packages from Target and Best Buy that arrive just as the Domino’s delivery guy knocks on our doors with a few pizzas in hand that we pay for with fresh stimulus money from Uncle Sam . You get the idea.
We are also supposed to be in awe that recent economic activity shows a pronounced bounce after the lockdowns. The economy is holding up from a broad perspective for now because enormous sums were thrown at it by the government, but it remains a long way from returning to even the unexciting pre-pandemic levels of output. From an investment standpoint, the catalyst for a reversal of the current market dynamics may lie in a gradual return to how the world operated for decades before the pandemic with some small modifications.
If you break down the economy by industries and income tax brackets, you see some companies and people doing quite well and others doing incredibly badly. The divergence in fortunes between the white-collar investor class and many large companies that mostly appear to feel bulletproof right now and the rest of the world is not something we have witnessed in any prior period of our careers to this degree.
Over 20 million people are out of work if you combine the various unemployment assistance programs. That is worse than recessionary, yet the talking heads seem unaware of this tragedy even as jobless claims remain stuck at frightening levels.
This landscape makes us more than a little uneasy and sympathetic to those that have not benefited by how the deciders chose to allocate the rescue efforts and reward their cronies. Something has to give, but we do not expect the election to resolve the social unrest. We do suspect that a less quarantined economy with reduced total federal assistance directed squarely at those who need it might reduce the palpable tensions. Those with jobs don’t need another round of $1,200 checks, but helping individuals that cannot find a job makes enormous sense.
Talk of the need for additional fiscal stimulus will not go away because many investors fear the path forward is fraught with numerous risks of rolling back into the chaos of March and April. However, for now, most remain invested because they expect more handouts in the silly amounts disbursed in recent months.
The Fed is financing a large portion of the federal spending spree. That pays for current consumption, but these are not the sort of expenditures that might foster meaningful long-term growth. A dollar of debt only buys about 30 cents of growth these days. That is half of what we got a few decades ago and has been declining for years.
We recently read a piece in which one seasoned value investor referred to the investing landscape as a “mental asylum” given the valuation disparities between favored and unfavored stocks. This has been compounded by growth and value stocks moving in opposite directions in a big way this year after years of value stocks simply lagging miserably. The pandemic caused a huge wave in this direction.
At the same time, another dominant factor is market cap because in the age of passive investing, almost nothing else matters. That leaves a lot of decent businesses being left for dead. An investor who owns these unloved companies in their entirety will be receiving compelling levels of cash flow every year. For instance, we recently found a solid insurance claims management company with low debt and a double-digit free cash flow yield. That is compelling versus a lot of better-known stocks with yields near zero.
While we love to get into the trees of researching value ideas and have been especially busy with that lately, we still have to keep an eye on the forest. The real risk is extreme overvaluation of large segments of the equity market given the amount of intense speculation taking place. It will probably resolve itself over a longer time frame of quarters, not days or weeks. As a result, a low net exposure remains appropriate. The only period to rival current levels of giddiness is 1999-2000 as participants refuse to acknowledge any bad news or uncertainty
We see a new tech bubble being disguised as monetary policy success with Fed patting itself on the back and taking credit where little is due. We remind investors that the only net cash that flowed into stocks in this cycle was from corporate buybacks aided by enormous borrowing. Investors did not throw cash at stocks because of QE despite the endless narrative to the contrary. The market experienced significant crashes twice in the last two years because faith in the Fed gave way to reality.
While it is impossible to find a period when the stocks with current median valuations traded more expensively in the last 100 years, apparently investors can imagine that they will, or they would not be buying or holding current positions. At the same time, while value and growth stocks have spent much of that same period trading at much tighter relative valuations with value stocks generally outperforming, investors cannot imagine that they ever will again. We like those odds, especially when we are getting paid to take them.
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.