Reasons to be Fearful, Reasons to be Cheerful, part Two
Reasons to be Fearful, Reasons to be Cheerful, Part One was a general overview of the first of the Haddam Road Advisors Three Question Focus:
- What’s going on in the Economy?
- Here’s a link: https://tinyurl.com/FearfulCheerfulPartOne
Below we will address Question Two:
- What’s going on in the Financial Markets? Let’s get to it.
A Reason to be Cheerful: The shortest bear market in History
On February 19 of this year the S&P 500 closed at 3386. Thirty-three days later the index closed at 2237, a dramatic downdraft. On August 21st the index waved “hello again” and passed by the Feb 19th level; it is continuing to move slowly higher:
S&P500 index: source thinkpipes and author.
For those of you counting that’s 184 days for a 34% drop and a 52% bounce. That’s a rollercoaster ride I’d say none of us want to experience again. Will we? Well…
A Reason to be Fearful: Valuation; are equities worth it up here?
This market is very narrow. What do I mean? Here’s a $2 Trillion example.
Below is a graph by Dave Wilson of Bloomberg Radio (Twitter: @TheOneDave ) that I think illustrates this most dramatically. The market value of Apple (AAPL) is currently within striking distance of the total value of the Russell 2000 index (comprising 2000 of the smaller sized stocks listed in the US):
Source: https://theonedave.tumblr.com/
Let’s spend a minute looking at this. In 2016 Apple was worth approximately $500 Billion and the Russell 2000 approximately $1.8 Trillion. Fast forward to today, their respective market values are $2.2T vs. $2T. Would you rather own one company worth $2 Trillion or 2000 smaller companies that in total are worth slightly more than that?
Obviously in retrospect AAPL is a no brainer, but going forward which offers more upside? In which position are you more diversified?
Apple is a legendary company with stellar management and an exceptional financial position but… really?
Another example of narrowness: Tesla. TSLA stock is now worth more than (wait for it), Toyota, Volkswagen, General Motors, Ford, and Ferrari… COMBINED. And maybe it should be given their exceptional technology, but they sold 367,500 vehicles worldwide last year, Toyota and Volkswagen both sold over 10 million cars each. TSLA may execute brilliantly over the next 5 years and justify this valuation, but they may not. Therein lies the risk.
There is a dichotomy in this market and in the economy (remember, they are two different things). The super-optimistic narratives like AAPL and TSLA are driving this market higher, versus a broader swathe of companies who may be struggling to open or stay open, maintain or re-establish cash flows, and who may never fully recover from this pandemic.
Active stock selection and portfolio management will become more important than ever over the next five years to navigate this new world.
Reason to be Cheerful: Markets are functioning ‘normally’
Let’s look at current conditions. The St Louis Fed Financial Stress Index was formulated to address the question, “are markets functioning properly?”.
Source: https://fred.stlouisfed.org/series/STLFSI2
The short answer is, “Yes”. There were severe dislocations in bond and stock markets in March and April and the incredibly rapid and supportive monetary actions of the Federal Reserve, combined with the mammoth fiscal support program we covered in part one, set the foundation for this equity rally back to new market highs and for a retracement in the bond market.
A reason to be fearful: The Federal Reserve has a stratospheric balance sheet
Source: https://fred.stlouisfed.org/series/WTREGEN
The Fed achieved a level of financial stability, but at what cost? The Fed has pumped an unfathomable amount of money into the economy which have the potential to create dislocations that macroeconomists and market strategists are performing their own version of Twister* to analyze. Japan started down this road in the 1990’s (partly to combat a demographic time bomb) and are still expanding their balance sheet at big-bang speed today with no exit in sight.
A Reason to be Cheerful: Money is free!
The graph below is a history of the 30-year Fixed Rate Mortgage, it is below 3% for the first time ever:
Source: <a href='https://www.macrotrends.net/2604/30-year-fixed-mortgage-rate-chart'>30 Year Fixed Mortgage Rate - Historical Chart</a>
That creates a windfall for those who qualify to re-finance and can help to build an economic tailwind going forward. Likewise, businesses are enjoying a window of opportunity to roll their indebtedness farther out in time at lower rates which creates another potential economic tailwind. But, as in all economic decisions, there is a tradeoff.
A Reason to be Fearful: Money is Free!
The Federal Reserve’s Zero Interest Rate Policy (ZIRP) has driven yields across all financial markets (corporate bonds, municipal bonds, mortgage bonds, US Treasuries, etc.) to all-time lows but is that a good thing?
There is a thing called the ‘risk-free rate’ that is used in pretty much all financial valuations; how do companies allocate capital going forward when this rate is effectively being manipulated to zero (or close to it) by the monetary authority? And if mistakes are made in allocating capital by companies, governments, and individuals, how does this affect the economy going forward?
That is not knowable yet, but this can create great uncertainty going forward. What does this matter to you?
The third question of the Haddam Road Advisors focus is:
- How do current Economic and Financial conditions potentially affect HRA client’s lifestyle, investments, and future well-being?
That is a question we’ll address in ‘Reasons to be Fearful, Reasons to be Cheerful, part Three”; we’ll highlight some things to be aware of in your portfolios and the potential risks involved, namely:
- Convexity
- Liquidity
- Volatility
I enjoy working with clients who want to understand their finances and be actively involved in shaping their future. Please contact me if you have any questions or comments. Change Happens.
Brian Kearns, CPA
Haddam Road Advisors
Financial Planner / Portfolio Manager
1603 Orrington Ave, Suite 600
Evanston, IL 60201
Ph: 312 636 3067
www.haddamroad.com
NOTE: This is being provided for informational purposes only and should not be construed as a recommendation to buy or sell any specific securities. Past performance is no guarantee of future results and all investing involves risk. Index returns shown are not reflective of actual performance nor reflect fees and expenses applicable to investing. One cannot invest directly in an index. The views expressed are those of Haddam Road Advisors and do not necessarily reflect the views of Mutual Advisors, LLC or any of its affiliates.
Investment advisory services offered through Mutual Advisors, LLC DBA Haddam Road Advisors, a SEC registered investment adviser.
* “Twister image: https://en.wikipedia.org/wiki/File:1966_Twister_Cover.jpg
