Looking for the “Shortcut”
June 12, 2020
Chances are you have taken a “shortcut” or two during your life. Seeking out a shortcut is a basic human response. It is an emotional response and our emotions can lead us to take actions that negatively impact our journey instead of making it better. Over the past month, we have seen the stock market and its investors take the shortcut amid the current economic storm. With markets touching neutral levels on a year to date basis this week and the Nasdaq breaking 10,000 for the first time ever, we must remember that markets are emotional on the way up, and they are emotional on the way down.
Many would say that 2020 is not off to a good start. The storms are plentiful with COVID-19, the economic halt, depression level unemployment, racial injustice issues, protesting, rioting and the like. With storms like this brewing it leads to polarizing opinions that are driven by emotion. Amid the turmoil, we seek out the shortcut to break up the storm.
The “shortcut” is that there is no shortcut. There is no easy way out. Life is a journey and life is hard. A journey is taking one step at a time with careful planning along the way. Economies, like people, are moved incrementally. The journey starts with commitment, but commitment is only the first step. A successful path forward is the compounding of many conscious and intentional actions set to work in tandem with each other as momentum builds. We must become comfortable taking small steps in order to create the potential for big wins. This economic recovery will be a marathon, not a sprint. We must be patient in our approach and stick to a carefully coordinated strategy. In portfolio management, risk matters, which is why we chose to manage risk and allow the portfolio the opportunity to generate return.
Retirement contributions and new enrollments in employer sponsored plans have tumbled to record lows amid the coronavirus pandemic. One of the first things to go during layoffs and furloughs is retirement plan contributions. People quickly narrow their focus to the short term and forgo the long term. It is a natural human response. The question then becomes, “What should you do during difficult times?”
Recently one of my peers in the industry said, “It is clear that the pandemic and its economic effect is taking a major toll on employers and those participating in retirement plans. Many have been laid off or furloughed which immediately stops their contributions.” According to the Retirement Plan Advisor Index in partnership with ADP, new participants in retirement plans have dropped 34.4% in the past two months. Those contributing to their employee sponsored plans are down 20.9% during the same time period. Overall dollar contributions are down 34.6% in the past year. Many are in a wait-and-see mode as the economy restarts. This trend will have a lasting effect on the retirement asset base in the future. The lower the asset base; the lower the available income stream during retirement.
With the increased volatility in the stock market, many retirement plan participants did the exact opposite of what one should do. During times of volatility, one should be looking to take advantage of lower share prices. If they maintain their contribution during the volatility, they buy more shares with each contribution which facilitates a faster recovery.
Are we living in an alternate dimension?
Markets are operating in an alternate dimension to the real-world banking on future earnings for multiple years that appear more certain than earnings this year. In this alternative dimension, there are at least two main reasons for the rebound that we see.
First, the expectations for earnings this year have fallen significantly while the earnings expectations for 2021 and 2022 are not showing a significant reduction. This effect is very different than the Great Financial Crisis. In 2008, at the height of the crisis, earnings expectations for that year fell 28%. In 2020, we have seen a similar position at 27%. However, when we look at future earnings, a difference reveals itself. In 2008, future earnings expectations for 2010 fell by 26%. So far in 2020, future earnings expectations for 2022 have only fallen 13%. There is an argument that this crisis unfolded so rapidly that the expectations have not had time to catch up; however, optimism around reopening is likely a contributing factor, along with massive fiscal and monetary stimulus.
Second, there are valuation perception changes at play. Investors appear to be willing to pay more for future earnings than they were 10 years ago during the Great Financial Crisis. Low interest rates are contributing to this dynamic in a major way. The 10-year treasury note is currently less than 1%, which, comparatively, was at 4% at the beginning of 2008. This has caused a decline in the cost of capital which is used to discount future earnings. A lower cost of capital changes the flexibility of companies in their response during the recovery in this crisis. Low interest rates have also caused equity risk to appear more attractive on a relative basis when looking at the balance of risk and return. The dividend of the S&P500 is currently 32% greater than the yield of the U.S. Corporate Bond Index.
One of the most significant factors is the confidence investors have in the mega-cap tech companies, better known as FANG+. These mega-cap stocks now make up 24% of the S&P500. Many institutional investors are positioning in these companies due to the large amounts of cash they have on their balance sheets. The general theory is that these large, financially healthy companies will continue to deliver impressive earnings growth when the crisis is over, and that is what continues to drive the market movements. The weight of these companies and their performance is significant in driving index performance.
From an economic and a market perspective, there are signs of recovery and cause for optimism. There is ample liquidity in the markets, and many businesses have devised innovative solutions to adapt in this unprecedented period. The global output cycle is likely to be well on its way to returning to pre-COVID level. There is a huge pent-up demand, poised for release, as states re-open for business. This is most notable in developed economies primarily due to savings and stimulus.
What is driving the disconnect between the stock market and the economy?
The market hates uncertainty more than it does bad news. In the month of March, everything was uncertain. In April and May, the corporate and economic data began to roll in which revealed bad news, but at least a bit of the uncertainty was gone. Uncertainty is one of the markets biggest issues and drives the most fear with investors- particularly institutional investors.
It is also important to remember that economic data looks backward, and the market looks forward- neither of them are real time. This is a common misconception. A great example of this was this week when it was declared that the US was in a recession, and it began back in February. Well, anyone with an understanding of the economy probably knew in early March that we were in a recession.
Another major disconnect is that low bond yields make it harder for investors to turn away from stocks. Going into the pandemic, bond yields were already low. We have never gone into a recession, or a bear market, with yields this low. During the pandemic, investors didn’t see an alternative to stocks, which led them to companies with dividends and cash heavy balance sheets.
To me, the largest impact came from the monetary and fiscal policy measures that were rapidly put in place. The quick reaction from the Federal Reserve to sure up liquidity and the government to passing the CARES act, made all the difference. These features of “easy monetary policy” provided sunshine in a stormy environment.
For the time being, do not be surprised if the market continues to move independently of bad economic news. The market overshot itself on the way down, and it has certainly overshot itself on the way back up as well. The right answer is somewhere in the middle, and it will take more corporate reporting data to help find the midpoint. At the current levels, the S&P500 is trading at a 21x forward looking P/E. Historically the average is near 17x. At 17x, it would be trading around 2700.
Our ongoing strategy has been focused on the investments themselves and not getting caught up in the short term market fluctuations. After all, the stock market is not the appropriate place for short-term dollars. It is important to stay focused on the things we can control which is an assessment of risk first when building a portfolio and allowing the return to be created from the risk-adjusted approach.
Simply put, the stock market is being supported by investor optimism about the economy 12-24 months from now and not today’s reality. However, if the economic turnaround that is expected doesn’t materialize, or we have a second wave of COVID-19, then the stock market will reset. My view of the recovery still remains a W. The emotions of re-opening have driven the market to levels that are unsupported- particularly in the technology sector. The third quarter in 2020 is the most likely time for a market pullback.
Steps to Simplicity – an often overlooked state
It is challenging to live simply in a very complex world, but in order to live a healthy and balanced life, we must be able to find the simplicity. How? Learn to say no, take a social media detox, watch the sunset, listen to the ocean, spend time in nature, connect spiritually. Without an effective balance, burnout sets in, and with burnout everything in life gets complex.
To avoid an emotional burnout, work to live a life of intention, passion and purpose. Start with defining what’s important to you. Without understanding who you are, then you are always open to significant influence. Plan your day. Without a plan, you will lose valuable time. Set long-term goals that coincide with your short-term plans. Don’t be afraid to take action; the first step is always the hardest. Be challenged in your faith. Focus on the people that mean the most to you. Seek a change of pace if you are overwhelmed.
During a time of devotion last Friday at my office, I challenged my staff to “flip the script.” Amid the negative, do the positive. Be the light in a very dark world. By being the light, we begin to understand the truth about ourselves; it enables us to interpret our world, and it makes us stronger. My challenge to you as well is to “flip the script.” Don’t allow the polarizing negative influencers to bait you into their narrative. Write your own story and be the light.
Managing Partner, Capital Investment Services
Financial Advisor, RJFS
Capital Investment Services, LLC is not a registered broker/dealer, and is independent of Raymond James Financial Services. Investment Advisory Services offered through Raymond James Financial Services Advisors, Inc. Securities are offered through Raymond James Financial Services, Inc. Member FINRA/SIPC.
This material is being provided for information purposes only. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Opinions expressed are those of Bobby Lumpkin and are not necessarily those of Raymond James. All opinions are as of this date and are subject to change without notice. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no guarantee these statements, opinions, trends, or forecasts provided herein will prove to be correct. Investing involves risk and may occur a profit or loss regardless of strategy selected, including diversification and asset allocation. Holding stocks for the long-term does not insure a profitable outcome. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. The S&P 500 is an unmanaged index of 500 widely held stocks that’s generally considered representative of the U.S. stock market. The Dow Jones Industrial Average (DJIA), commonly known as “The Dow” is an index representing 30 stock of companies maintained and reviewed by the editors of the Wall Street Journal. Prior to making an investment decision, please consult with your financial advisor about your individual situation. The NASDAQ composite is an unmanaged index of securities traded on the NASDAQ system. Dollar-cost averaging cannot guarantee a profit or protect against a loss, and you should consider your financial ability to continue purchases through periods of low-price levels. Dividends are not guaranteed and must be authorized by the company’s board of directors.
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