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September 2020 Economic Update

September 2020 Economic Update
 

Can this market keep moving higher? The short answer, in my opinion, is “yes” I believe that it will. We will explore that a bit more below.

When you stand and watch the ocean hit the rocky shoreline, there is typically a pattern that you can identify. Waves tend to come in sets and there are reasons behind why the swell is a specific size on a particular day. Once in awhile there is a big wave that seems to come out of nowhere. That is the wave that sweeps the inexperienced person off the rocks and carries them into the ocean. Despite constant warnings, people are injured or even killed every year because they ventured too close and were caught by that big wave. We see more inexperienced investors gathering on the proverbial rocks to watch the waves of this market continue to move higher. If you see any of these folks, please warn them of the dangers of getting too close. We are always happy to talk and help them understand how to participate relatively safely. As with all markets, we have never seen precisely this set of scenarios play out before. We have seen different combinations of these circumstances and from that experience I believe we can forecast some ideas of what may happen going forward. 

  • Can the market go higher? 
  • Innovation and Investing

Can the market go higher? 
We remain aware that a potential for a “second wave” exists. However, so long as governments worldwide continue to add money to the system, the underlying problems continue to be kept at bay. Small business loans, rent payments, and individual home mortgages remain unpaid. Banks continue to add to their loan loss reserves indicating they are concerned a day of reckoning will come. Still, some businesses and individuals can take advantage of lower interest rates and other economic incentives to drive the economy and stock market higher. Additionally, some innovative companies were positioned well to profit from this environment and are pushing markets higher. 
 
Yes, the market can go higher. I believe it will likely go higher particularly in the longer term and there are three reasons I explain below:

  1. The government continues to push liquidity into the market both in terms of actual cash delivered to individuals and exceptionally low interest rates.
  2. Neither political party has an incentive to crush voters by not approving some new relief after the recess. Even if there is a delay, banks have little incentive to foreclose on tremendous amounts of debt right away. 
  3. Perhaps most important is that we are at the very beginning of not just one innovation like the industrial revolution of the past but three major innovations converging and integrating at once.

The first and second items mentioned above have led to: 

  • Increases in purchasing as evidenced by a robust PMI (Purchasing Managers Index) number of 56 in August, up from 54.2 in July 2020 (anything above 50 is considered expansionary)
  • Building permits are 9.4% higher than the July 2019 numbers
  • Housing starts are 23.4% higher than the July 2019 numbers

All of this helps sales of materials and home improvement items and puts some people back to work while others continue to suffer from the pandemic shutdown.
 
One item that bears mentioning and a word of caution is decreasing diversification which is one of the critical tenants of risk management. There is a trend of concentration among the largest companies in major indices. Five companies now make up over 25% of the S&P 500 and about one-third of the NASDAQ 100. This concentration has led some to be concerned that less experienced investors may believe they are more diversified than they actually are. This is not to say that these companies are significantly overvalued as some might suggest. 
 
Many P/E (price to earnings) ratios seem stretched. However, if you look a bit deeper at the PEG ratio (price-earnings to growth) combined with historically low-interest rates, a different perspective may emerge. Still, we caution against sacrificing diversificationTime and experience have taught us to harvest gains systematically. We see many opportunities in the cutting-edge innovation space that allow for prudent diversification.
 
Innovation and Investing:
While logic may seem to indicate that massive defaults and bankruptcies building in the background means that the market and economy should be headed down. These are reasonable fears and I share them. The reason I am not as concerned as others may be is because I see a massive adjustment in progress.   
 
I have long been a fan of and studied innovation and investing. Throughout history identifying and capitalizing on the next step in human evolution has been profitable, particularly in the United States. We see a situation where a new industrial revolution meets innovations in information technology while integrating with nearly every market sector. Here again we can be concerned, we can “not like it,” but trying to stop it would be like standing in front of a speeding freight train and attempting to stop it single-handedly.  
 
Let me try and explain through a recent example:

The U.S. pitted their best air force fighter pilot against Artificial Intelligence (AI) competitors in multiple F-16 dogfights. The result was conclusive. Every time the AI prototypes bested the air force pilot. The reason for this is that AI learns, never gets tired, and never forgets. The first several thousand times the AI attempted to fly, it flew into simulated buildings, the ground, etc. But AI does not need to rest or slow down. AI does not get frustrated and has no fear. It continued to learn and adapt using only milliseconds between millions of simulations. (One hopes this technology does not get into the wrong hands which, of course, is where massive steps forward in cybersecurity come into play.)

 
The 5G speed (no, it is not just used to make your phone download a movie faster) is now fully functional globally. The 5G technology enables communication fast enough to allow the now largely perfected and uniquely adapted robots to perform tasks in real-time from anywhere in the world. Some of these tasks include specialized surgeries, mining operations in space, the deep sea, and any other scenario you might wish to imagine. 
 
While this may seem disturbing as visions of old Terminator movies and “Skynet” start to dance in your head, there is good news. As with so many innovations, the AI revolution began with a game. A chess game where IBM’s Watson soundly beat Garry Kasparov. Rather than become despondent, Kasparov worked with IBM and through the years the team has found that consistently an AI vs. a human competitor ends with the AI on top. However, when an AI teamed with a skilled human chess player competes against just an AI alone, the AI/human team consistently wins. Numerous studies across various fields of study have yielded the same results.
 
There are many opportunities to participate in the innovation revolution and keep prudent risk management, including appropriate diversification in mind. We are here to help.
 
Just a quick reminder to our readers this note is not individual investment advice. Personal investment advice requires conversations directly with the individual concerned and developing a specific plan tailored to your situation. We are happy to have such a discussion with you, and you can schedule by clicking here .