Third Quarter 2020 Market Outlook
I recently traveled from Traverse City, MI to Honolulu, HI. It was my first time interacting with strangers in nearly four months. It seemed that many of my fellow travelers had also been yearning to talk to new (mask covered) faces, as each struck up a conversation. Long before our conversation ventured to the typical talking points of careers, families, news, sports etc., my companions brought up the stock market. Each had unique insights and tips, supported by what I assume has been great performance since March. By the end of the third investing conversation in three flights, my excitement to be discussing something I love - investing - had faded. I was reminded of a quote by Bernard Baruch, a successful Wall Street trader, who famously said, “Taxi drivers told you what to buy. The shoeshine boy could give you a summary of the day's financial news as he worked with rag and polish. An old beggar who regularly patrolled the street in front of my office now gave me tips and, I suppose, spent the money I and others gave him in the market. My cook had a brokerage account and followed the ticker closely." Baruch viewed it as a bearish sign that the market was over-loved and in turn, overvalued. This was before the 1929 stock market crash. I am not pleased to join the chorus of professional investors writing about the parallels of today and past market tops, but it is hard to not recognize that we are navigating risky times. While the interactions I had on my flight were anecdotal, many more robust measures of market exuberance are flashing red as well.
Before we get into the indicators that are flashing overvaluation, I think it is important to first understand why many smart and knowledgeable investors invest at these valuation levels. When buying a share in a company, you are buying a share in the company's current and future earnings. Some companies have rosier futures and are projected to grow earnings substantially in the coming years. So, logically, they will trade at a high multiple to current earnings. This is the premise of growth investing. Growth investors believe that it is reasonable, if not desirable, to buy great companies with large growth opportunities regardless of the current valuation with the belief that the company will “grow” into the valuation. This is how companies like recently IPO’d Snowflake can trade for such high multiples. As of the writing of this article Snowflake is currently worth $75 billion with only $403 million in trailing 12-month revenues (NOT earnings.) This means that investors are currently willing to pay 183 dollars for each dollar of revenues (again, NOT earnings.) While this valuation is amazing if not absurd, it does not necessarily mean that Snowflake is overvalued. It only means that current investors, like beloved Warren Buffett's Berkshire Hathaway, see such a promising future that they are willing to “pay up” for a great quality company. There are many cases of such strong conviction in companies' futures right now, many of which were names mentioned to me by my fellow travelers: Tesla (16x sales), Shopify (53x sales), and Zoom (84x sales.) The risk with high valuations is that if the narrative changes, share prices can quickly and drastically fall without the backstop of assets or current earnings. This is how the NASDAQ dropped 77% during the dotcom bubble. Also, future earnings are less predictable, have greater uncertainty, and rely heavily on assumptions. One large assumption is the rate at which you discount these future cash flows - predominately a function of earnings - back to the present. This rate, aptly called the discount rate, is the answer to the question: “How much would I pay now for a dollar from this company in the future?” When estimating this rate, analysts typically take the 10-year treasury rate and add risk premiums onto it (as US Treasuries are considered risk free.) With rates historically low right now, the rate at which these future cash flows are discounted is lower and thus makes a future dollar worth more. For example, if the discount rate used was 7% (10-year rate before housing bubble and QE + 2% risk premium,) a dollar 10 years from now would be worth about $0.51. However, with a discount rate of 2.71% (current 10-year rate + 2% risk premium,) that same dollar would be worth about $0.77, or 50.98% more. As you can see, lower discount rates, and rates in general, make future cash flows more valuable at present value and thus increase the share of company’s values assigned to future less predictable and inherently riskier cash flows.
Long - but I believe, important - digression over, let us get to some of the metrics signaling that risk may not be appropriately discounted in the market. Warren Buffet is famous for saying that total market cap to gross domestic product ratio is “probably the best single measure of where valuations stand at any given moment.” This chart shows the value of all publicly-traded securities as a percentage of the United States gross domestic product, which measures the total value of goods produced and services provided for one year. It currently stands at about 182%. This is well above the levels seen during the dotcom bubble and is around the highest it has ever been. Total market cap values are largely a function of GDP, with fluctuations occurring because of increases in multiples (how much investors are willing to pay,) and changes in the percentage of GDP attributable to public sector companies. In the long run, the latter two are constant (mean reverting,) and thus the only sustainable growth in company valuations can be attributed to economic growth. With the currently high levels, investors are saying that we are going to see unprecedented growth in GDP and earnings in the coming years.
But why do investors believe this? The economic backdrop paints a far different picture than what you would imagine would lead to such exuberance. Yes, COVID has had a positive impact on many large, predominantly tech companies who make up a greater share of market indexes than ever before. Unfortunately for this narrative, however, consumer spending accounts for nearly 70% of GDP. This is why having a healthy workforce is imperative for economic and financial market growth. In the end, someone must buy goods and services. That is something even the most accommodating Federal Reserve cannot do. As of August, total nonfarm payrolls stand at just shy of 141 million, slightly above the employment level we saw before the great recession and down nearly 12 million from February. I believe this figure paints a far better picture of growth, than the more commonly followed unemployment rate which does not show Americans that no longer want to participate in the workforce. Both the unemployed and those that are no longer seeking work have impacts on consumer spending. Important to this chart is the speed of change - the second derivative of the recovery is far more important than the actual numerical figure. If we are to see some leveling off in the rate of re-employment, we should expect to see financial markets react negatively.
Looking at the psyche of the American consumer, we are starting to see consumer confidence move in the right direction. However, alternative data sources show that many Americans are struggling to meet their most basic needs. More people are googling “eviction” than ever before. I would prefer policymakers use a more sustainable approach, but I would expect some sort of relief to come to those in need in the form of fiscal stimulus similar to the CARES Act. The market, the economy, and most importantly those worried about being evicted are reliant on it. I would like to think it would be the latter two that catalyze the stimulus, but the market has all but priced in its occurrence. Meaning that if we are to see delays, contestation, or other obstacles to a stimulus bill passing we will likely see the market react negatively to the notion of no fiscal stimulus until November (or maybe later.)
It is important to note that markets are forward-looking, while most economic indicators are lagging. This means that the market will typically start to recover even as economic data continues to come out negative. Yet most of the challenges we are facing today are outside of the scope of typical risk models. There is an unprecedented amount of uncertainty surrounding a second wave of COVID, potential inability of Congress to pass an additional stimulus package, election uncertainty, and the potential delay of a vaccine.
Market fears seem to have been put at ease by recent Federal Reserve actions, which have created the allusion of a backstop for equity markets. Since the volatility we saw in March, the Fed has injected $2.85 trillion in liquidity into the market. My father, who professionally managed money through the dotcom bubble, is famous for saying that “all unsustainable trends are unsustainable.” An insightful statement I know, but at times the market can find a reason to believe that it “will be different this time.” I’m here to say that this time is not different: injection of liquidity at this scale is unsustainable. Since March 4th, the Federal Reserve's balance sheet has grown from an already-elevated quantitative easing value of $4.16 trillion to $7.01 trillion. If we were to continue at this pace, the FED’s balance sheet would equal the value of all companies within the S&P 500 (roughly $29t) by February of 2025.
Even with the most beautiful economic data trends, global peace, politicians across the globe uniting with the singular goal of making the markets go up, helicopter money for everyone, and a solution to inflation, I would not feel comfortable with current valuations. These reservations are only amplified by the backdrop of uncertainty. This is a time to be slightly more conservative, adopt a long-term approach, and evaluate options based on how they affect goals. As you know we are practitioners, not academics, and you will see this in your portfolio. Two important decisions have been made to lower risk and focus on long-term growth in client portfolios:
Portfolios have been tilted toward value, international and emerging markets, and small cap stocks. The major area of overvaluation in the market right now lies predominantly in U.S. large cap technology. We believe tilting exposures away from large cap US technology will not only help insulate portfolios from the possibility of mean reversion in technology multiples, but also may add additional yield. Dividend yield is a function of the dividend amount divided by the price paid per share. Companies with higher valuation will have lower yields due to having a higher numerator (price.) Thus, dividend yield can be a simple metric to show general market sentiment across the globe. Below are the current dividend yields for the market segments mentioned above.
Also, we are viewing cash as a valuable asset, akin to a call option on the market if we are to see volatility in the coming months. Expect to see this cash deployed (found in your portfolio as short-term bonds, treasuries, money market funds, and cash) into equities if we are to see a meaningful correction.
The above chart shows the VIX, which most people know as the “fear gauge,” or a measure of how much fear is currently in the market. While that is true to an extent, the VIX has more real meanings, which directly relate to how options are priced. The VIX is a measure of implied volatility, or how much investors expect the S&P 500 to move in the next 30 days. A component of options pricing is this volatility, with higher expectation of volatility leading to higher prices for options. In essence, when the VIX is high, options will generally be worth more. Following on our view of cash as a free call option on the market, the value of this position is also more valuable at present. As you can see by the chart, volatility expectations are higher than normal with VIX at a level of around 26 - well above the historic average.
This is not to say we are sitting around waiting for a market crash. It pays to be an optimist in life, and even more so in investing. There will always be uncertainty and risk, and there's always a possibility of losing money when investing. Many professional investors, some very famous, have been calling for a crash since the rally began in March. While their logic is sound, timing the market is a fool's errand. Even those in the best position to predict recessions, contractions, and market volatility are rarely able to do so. A good example of this is the International Monetary Fund’s track record at predicting recessions. The graphic below shows the IMF forecast for the number of countries in a recession each year. As you can see, even the IMF - an organization that has all the resources, Ivy League economists, connections, and data to be able to predict a recession - has a questionable track record. Private sector predictions have been terribly wrong as well. This shows how hard it is to predict and make investment decisions based upon macro market theories, which seems more akin to a gamble.
Rather than viewing ourselves as market timers, or market gurus, we view our job as evaluating risk and return and how they relate to clients achieving their goals. By having a higher cash position than portfolio theory would suggest and over weighting value; we believe investors are currently asymmetrically compensated for the positions. The decisions to overweight value, and have a slightly higher cash position fit in with many other small decisions such as intentionally rebalancing, diversification, tax loss harvesting and locating assets in the most tax efficient accounts that we believe will add to returns over the long run. Additionally, these decisions are intended to help safeguard portfolios against the far left tail event that could drastically impact clients ability to reach their goals.
Please reach out with any questions, comments, grammatical errors found in my writing, or just to talk. I look forward to hearing from you.
Sutherland Integrated Investment Management Group, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.