2020 2nd Quarter Market Commentary

Late in the second quarter, I wrote To Be Equity-Lite or Equity-Heavy?, which spelled out the predominant arguments for and against significant equity ownership in the current environment. I encourage you to read or reread that article to evaluate your own reasons for remaining either equity-lite or equity-heavy.

Departing from our typical Quarterly Commentary format, in this one I will summarize recent advice from well-known, often widely respected economists, monetary officials and investors. What becomes quickly apparent is the profound diversity of views and the unprecedented prevailing uncertainty.

The first half of 2020 contained the most dramatic combination of stock market collapse and rapid recovery in US history. As the pandemic hit and businesses closed, we experienced a 35% decline in less than a month and a half of the first quarter. A second quarter rally recovered the majority of that loss, as the Federal Reserve unleashed its most powerful monetary stimulus program ever. The massive reversal rally, with global economic statistics exhibiting generational negative readings, is testimony to faith in the Fed and to an ingrained expectation that central bankers can overpower even the weakest of economic conditions. As usual, brokerage analysts supported the rally with buy ratings on the vast majority of stocks. Even firms with cautious short-term ratings continue to justify positive outlooks because of enthusiastic forecasts for 2021 and 2022.

So persistent has been the rally from the March lows that millions of new investors have decided to take advantage of what appears to be a one-way market. Perhaps the most noteworthy newcomer is Dave Portnoy, founder of sports blog Barstool Sports. With virtually no active sports in the United States, Portnoy has funneled his betting instincts into day trading the stock market. Early success has led to such comments as: “It took me a while to figure out that the stock market isn’t connected to the economy. I tell people there are two rules to investing: Stocks only go up, and if you have any problems, see rule No. 1.” Following that philosophy has led to such gains that Portnoy immodestly proclaimed: “There’s nobody who can argue that Warren Buffett is better at the stock market than I am right now. I’m better than he is. That’s a fact. This is the easiest game I’ve ever played.” Portnoy has developed such a following that he was featured on a CNBC trading segment within the past few weeks. It brings to mind the apocryphal shoe shine boy giving stock tips to Ambassador Joe Kennedy before the crash in 1929. We’ll have to wait to see whether Portnoy will ultimately end up more successful than the legions of folks who left their jobs to become day traders in the late-1990s or house flippers before the housing collapse several years later.

There are, however, precious few well-seasoned analysts or investors willing to bet heavily on stocks unless the Fed and other major central bankers remain steadfast in their stimulus efforts.

The Fed itself has seen such economic malaise that it has initiated unparalleled rescue efforts. In addition to formerly unimaginable levels of money creation, its direct purchases of corporate debt securities have led Fed critics to claim that the central bank has already far exceeded the powers granted it by Congress. In just the past week, Fed speakers Brainard, Barkin and Kaplan have pointed to weak economic conditions as justification for continued, even increased, Fed accommodation. Voices calling for monetary discipline are remarkably faint. Consequently, few expect the Fed to reduce its support of the stock and bond markets.

For several years, we have argued that investors have had to make a highly uncertain bet. Either severe overvaluation will lead stocks to far lower levels to align with historically normal fundamental means, or central bankers will be willing and able to support stock prices despite severe overvaluation. The following commentary and forecasts are from individuals or organizations that I respect and whose views we weigh in our decision making. Their stock market expectations are far from universal. The economic commentary, however, is universally negative.

Organization for Economic Cooperation and Development (OECD)
The current recession will leave deeper scars than any peacetime recession in the past 100 years. Advanced economies will face a disappointing economic recovery.

International Monetary Fund (IMF)
The current crisis is “unlike anything the world has seen before.” While it is not a given, because the health crisis might alter consumer spending, with people potentially saving more, “It is possible with pent-up demand that there will be a quicker rebound, unlike after previous crises.” The pandemic has had a more negative impact on activity in the first half of 2020 than anticipated. The recovery is now projected to be more gradual than previously forecast.
Chief Economist Gita Gopinath warned that if health or economic conditions deteriorate, there could be “sharp corrections” in public securities markets. “With the relentless spread of the pandemic, prospects of long-lasting negative consequences for livelihoods, job security and inequality have grown more daunting.” About 20% of US companies are vulnerable to default or bankruptcy in this recession.

Bank for International Settlements
BIS, which supports the world’s central banks, warned that markets have become too complacent as risks from the pandemic threaten global prosperity.
“Financial markets may have become too complacent—given that we are still at an early stage of the crisis and its fallout. The shock to solvency is still to be fully felt.” The Bank warned that banks that have extended loans to companies and consumers will find themselves on the hook as businesses crash, taking workers down with them.

CEO Economic Outlook from the Business Roundtable
CEO outlook deteriorated in the second quarter. No meaningful recovery is anticipated in the second half of the year. Executives plan to reduce capital expenditures and hiring in the second half, amid slower expected sales growth.

Carmen Reinhart, Vice President and Chief Economist of the World Bank
The current crisis is similar to that of the 1930s. True recovery is a long way off in the US.

The following are opinions and forecasts of analysts and investors who have been particularly successful over the past few decades.

Mohamed El-Erian, Chief Economic Advisor at Allianz SE
According to El-Erian, the Fed is encouraging risk taking, and the stock market is completely disconnected from present and future fundamentals.
He posits that inflation is unpredictable. The deficiency of demand is disinflationary, while the huge supply of new money is inflationary.
Jobs won’t come back quickly.
The US and China will both end up worse off after the pandemic. This recession could turn into a depression if we can’t contain the virus or if a policy mistake leads to a market accident.
“The (market) narrative has been win-win. You win if you look though all the bad data and bet on a massive recovery. And you still win because the Fed will support you all the time. The narrative is so deeply embedded now that it takes a major shock to change it. It’s an uncomfortable bet to continue to bet on a huge recovery. I don’t like doing this.”

Stanley Druckenmiller, probably the most successful hedge fund manager of the past three decades, now managing just family money Druckenmiller saw the pandemic bursting the credit bubble that had built up for years. He still believes that to be the case long-term, although he doesn’t know the timetable.
“I had long-term concerns for the last few years that because of easy money, too much debt was being built up in the corporate sector. When Covid hit, I was pretty much of the view that there was a good chance that the credit bubble had finally burst and the unwinding of that leverage would take years.”
The debt bubble led him to see the stock market as overvalued. On May 12, he said: “The risk/reward for equity is maybe as bad as I’ve seen it in my career. The wildcard here is the Fed can always step up their (asset) purchases.” His thinking changed meaningfully after that. “I would say since that time, a couple of things have happened technically. I would also say I underestimated how many red lines and how far the Fed would go.” Because of good sector rotation and multiple breadth thrusts several weeks ago, he believed that equities could carry even higher. He cautioned at the time, however, that he could change his conviction in a flash, and if things go wrong, stocks could fall off a cliff.

Scott Minerd, Guggenheim Global CIO
Minerd appears to have a full appreciation of the potential for the economy and the securities markets to head in either direction. Without further Fed action, he foresees the “deluge of Treasury securities” likely pushing interest rates higher and threatening the overall economic expansion. He does, however, anticipate ongoing Fed action to include more quantitative easing, yield curve control, potentially negative interest rates, even the purchase of equities.
“Economic output will remain below potential for years to come as we deal with the pandemic and its long-term scarring effects.”
While seeing this environment to be similar to the bubble we lived through in the late-1990s, he still expects stocks to go higher.
The day of reckoning could be tomorrow or three years from now. In the meantime, continued Fed stimulus probably forces asset prices higher. “The probability of a setback between now and October is meaningful.”

Ned Davis, founder of Ned Davis Research, outstanding source of economic and securities market data since 1980
“Nearly every severe bear market accompanied by recession has at least two legs down.” Davis points out that most second legs have broken below the low of the first leg. “The recent bear market was closest to the one around the 9/11 terrorist attacks. That one also had a panic selling leg down, followed by a big rally for a number of months—similar to now—that was followed by a second leg down. While selling climax lows usually get tested with a “W” shaped bottom, there are exceptions to the rule. The biggest differences between now and the post- 9/11 rally are (1) more breadth thrusts; and (2) much greater Fed stimulus,” both of which are currently bullish.
“Without organic growth in income and more investment, I believe that once the government manipulation ends, the economy will struggle considerably. But for now, the economy is improving nicely.”

Ray Dalio’s Bridgewater Associates, one of the world’s largest hedge funds
Bridgewater maintains that the stock market could be on the verge of a “lost decade” for investors that would reverse a years-long trend of strong growth for corporate earnings. The percentage of zombie corporations in the US—those that can’t even fund their interest expense—is at an all-time high and kept alive only thanks to the Fed’s direct purchases of corporate bonds.

John Hussman, President, Hussman Investment Trust and Hussman Foundation, market historian with concentration on long-term stock market valuation measures
“The likely 10-year total return of the S&P 500 from current valuations is about -1.4% annually.” In early-July, “… our estimate of prospective 12-year returns on a passive investment mix again matched the most negative levels in U.S. history.”
“Our most reliable market valuation measures presently match the 1929 and 2000 extremes. Present conditions are characterized by an extreme overvalued, overbought, and overbullish syndrome.”

Charlie Munger, Vice Chairman of Berkshire Hathaway and Warren Buffett’s longtime business partner
In the early weeks of the current rally, Munger indicated to The Wall Street Journal why Berkshire was not jumping into more equities. “I would say basically we’re like the captain of a ship when the worst typhoon that’s ever happened comes. We just want to get though the typhoon, and we’d rather come out of it with a whole lot of liquidity. Nobody in America’s ever seen anything else like this. This thing is different. Everybody talks as if they know what’s going to happen, and nobody knows what’s going to happen.”
About whether another Great Depression is possible, he answered: “Of course we’re having a recession. The only question is how big it’s going to be and how long it’s going to last. I think we do know that this will pass. But how much damage, and how much recession, and how long it will last, nobody knows. I don’t think we’ll have a long-lasting Great Depression. I think government will be so active that we won’t have one like that. But we may have a different kind of mess. All this money-printing may start bothering us. I don’t think we know exactly what the macroeconomic consequences are going to be. I do think, sooner or later, we’ll have an economy back, which will be a moderate economy. It’s quite possible that never again—not again in a long time—will we have a level of employment again like we just lost. We may never get that back for all practical purposes. I don’t know. I don’t have the faintest idea whether the stock market is going to go lower than the old lows or whether it’s not.”
Berkshire did step up and buy the natural gas and storage business from Dominion Energy in early July, but this was less like buying an ongoing business than making a commodity purchase along with its storage and transmission system.

Jeremy Grantham, Co-Founder and Long-Term Investment Strategist of Grantham, Mayo and van Otterloo
Now in his 80s, Grantham has built much of his reputation by identifying speculative bubbles as they were unfolding. In GMO’s April 2010 Quarterly Letter, he outlined why he believes all bubbles revert to the mean: “You can only have that degree of confidence if you have been to the history books as much as we have and looked at every bubble and every bust. We have found that there are no exceptions. We are up to 34 completed bubbles. Every single one of them has broken all the way back to the trend that existed prior to the bubble forming, which is a very tough standard.”
“This is becoming the fourth real McCoy bubble of my career.” The first three he referred to were Japan in 1989, the dot.com bubble in 2000 and the housing crisis in 2007. He backed away from the first two of those bubbles two or more years early. That leads him to caution: “The great bubbles can go on for a long time and inflict a lot of pain.”
“This event is totally new and there can be no near certainties, merely strong possibilities.”
“In terms of risk and return—particularly of the worst possible outcomes compared to the best—the current market seems lost in one-sided optimism when prudence and patience seem much more appropriate.”
“Bankruptcies have already started and by year-end thousands of them will arrive into a peak of already existing corporate debt.”
Recognizing that central banks’ unprecedented stimulus efforts have “temporarily overwhelmed” underlying economic realities, he said: “It’s hard to believe that will continue.”
In a Financial Times interview, he said: “My confidence that this will end badly is increasing.” Last month in a CNBC interview, Grantham said that the US stock market is in an unprecedented bubble and investing in it is “simply playing with fire.” He has taken his portfolio to a net short position for the first time since the Financial Crisis. He suggested a good equity allocation in the US to be zero— “less than zero if you could stand it.”

Christopher Ailman, Chief Investment Officer of the $246 billion California State Teachers’ Retirement System (CALSTRS)
Ailman discloses that the fund is selling stock to be underweight. The first half of 2020 was the most difficult stretch for the market he has ever seen. Moves in stocks are “utterly absurd.”

Jerome Powell, Chairman of the Federal Reserve
Powell cautions that there is “significant uncertainty” about the recovery with small businesses at risk.

Robert Shiller, Nobel Prize winner in economics
Referring to the stock, bond and housing markets, Shiller warns that “It is a very risky time for all these markets.”

Anthony Fauci, M.D., Director of the National Institute of Allergy and Infectious Diseases
Referring to the pandemic in early July, Fauci stated that “We haven’t even begun to see the end of it yet.”

None of these seasoned market observers anticipate underlying economic strength without substantial, ongoing support from the Fed and other major central banks. Most expect that such support will be forthcoming for the foreseeable future. The open question is whether that monetary support will continue to outweigh declining corporate earnings, a growing list of corporate bankruptcies and historically high levels of unemployment.

Virtually all of these commentators point to extremely high levels of uncertainty on both medical and economic levels. The first half of this year offers dramatic testimony to the substantial penalties or rewards available in equities based on whether investors are successfully focusing on weak fundamentals or powerful government stimulus. With extreme uncertainty likely prevailing for a considerable period ahead, every investor should evaluate carefully whether the potential financial pain from being wrong would be less significant than the financial gain from being right. The hundreds of years of cumulative experience and wisdom of the respected individuals profiled above should provide valuable assistance in making that evaluation.

Please contact us if we can provide additional information about your portfolio or our investment thinking.

By Thomas J. Feeney, Chief Investment Officer