August 2020 Economic Update

August 2020 Economic Update

This year of unprecedented happenings has some of us perceiving that time is flying by.  For others who are used to moving about at will, time seems to have slowed to a crawl.  For nearly all of us, the way we do things has changed.  The same can be said of the businesses in which we invest.  Some have benefited, others have been hurt beyond repair, while still others have been damaged but have been able to adapt and may begin to thrive in the “new normal”. The word I used above, “unprecedented”, has been overused.  I hesitate to use it but no other word seems to fit.  One would need to go back to the days of the Spanish flu at the end of WWI to come up with anything comparable.  Given that the way in which we live has changed so much since that time I hardly find the comparison useful.  The pandemic has put the U.S. and the world into a state of panic and a spirit of fear seems to pervade all actions.  Add to this an ongoing major trade war, locust destroying crops in India which has led to an increase in starvation, and further tension between India, China, and Afghanistan.  Economic stimulus funds in the U.S. and around the world bring with it the threat of future inflation and have many concerned about the demise of the U.S. dollar.  As I warned last month, we did see an uptick in unemployment this past week and much of those claims came from higher income earners.  Now as we face increasing COVID-19 cases the picture may seem dire. America and other nations have, time and again, risen to become stronger after events such as these.  It has been said that necessity is the mother of invention and innovation and we are seeing that now.  The even better news for us here in the U.S. is that we tend to be the innovators of the world.  Not that innovation does not happen elsewhere, but the U.S. dominates the innovation space given our free market economy and the ability to profit handsomely from innovative work.

• What does it all mean for investors?

• What is the next move?

• Looking forward

What does it all mean for investors? The last two months I have spoken about the potential of a second wave of impact to the economy.  We are seeing some of those things happening slowly, possibly more slowly due to the incredible amount of stimulus monies flowing from governments around the world.  Contributing to this is the fact that we are in an election year where both parties struggle to find ways to make the other party look bad yet neither party wants to be blamed for an economic implosion. As I write this, the politicians are fighting in earnest over the latest stimulus package while everyday Americans and small businesses wait with bated breath on the ultimate outcome.  What some may miss is that small business in the U.S. directly contributes about 44% of the overall U.S. economic activity according to the Small Business Administration (SBA).  Further, according to the SBA, small business account for about half of all private sector employment.  These small businesses have much less margin for pandemic expenses and often depend on physical locations being available to operate.  Following this data and a May 20, 2020 report from the Washington Post puts the number of small businesses that have already failed at over 100,000 due to the pandemic.  Bloomberg News conducted a poll that suggests that small business owners as a group are not optimistic about their own prospects with over 50% indicating they will not survive past the next six months.  The alternative to providing continuing aid to small businesses is to see a massive rise in business failures leading to even more unemployed.  For this reason, we expect another round of stimulus to come soon despite the political bickering. Real Estate: Over the past decade or two there has been a migration to city centers and as more companies begin to announce they will allow working from home indefinitely that migration is starting to reverse.  While we remain concerned about increasing residential mortgage defaults given the rate of unemployment, for now the housing market is booming and as a result home improvement retail stores continue to do well.   If you have real estate holdings on either side of this equation these are things you should be considering. Stock Market: Everyone seems to want to be a day trader now.  This tends to happen when the overall market has an upward trajectory and a subsection of stocks have a particularly high breakout return to the upside (technology).  Combine these two conditions with many having more time on their hands and you see news that hundreds of thousands of new retail accounts are being opened and millions of trades are being placed every day lured by “free” trades.  Unfortunately, some of these folks will not realize the gains they had hoped and the ones that do may not realize the tax implications until next year at tax time.  In the meantime, these do it yourselfers are keeping the volatility high.  Not a day goes by that I do not see an advertisement with an outlandish claim suggesting that if someone signs up, they can help me make huge sums of money in a short period of time. Bond Market: Once again we are seeing that bonds continue to be more correlated to stocks as they have also moved higher propelled by lower interest rates and Federal Reserve direct purchases of individual bonds and Exchange Traded Funds (ETFs).  We again warn that traditional fixed income no longer plays the same risk mitigation role that it once did in portfolios.  They remain valuable to hold in most portfolios and do serve a purpose just not the same purpose as they once did.  Understanding this new relationship between fixed income and the rest of the market can make a big difference in accomplishing your objectives over time.

What’s the Next Move? Some who do not know me will ask me this question all the time.  People who know me well understand that my long-term investing strategy does not change from month to month.  We always remain at the ready to adapt but we do so slowly and systematically. Winners and losers:  Some like to find value plays by swooping in to purchase massively depressed share prices during these times.  We believe this is a dangerous game in the current environment.  While there are certainly value plays available, the massive and long-lasting changes we see are not likely to allow for quick recovery in many businesses.  We are seeing some value however in the big banking sector where bad news seems to be priced in and in the aerospace/defense sectors.  While the banks remain vulnerable, at these prices many of them are beginning to look attractive for the long-term investor.  Rotating cautiously in by rebalancing portfolios is something we are looking at closely.  Aerospace/defense stocks have taken a hit largely due to commercial airlines suffering but that is far from where all their earnings and profit come from.  Further, while defense spending may decline to some extent there is little to suggest a major move away from overall defense spending at this point. Technology stocks have been leading the way higher and the concentration of the major indices in technology continues to rise.  Unlike the technology bubble of the late 1990’s this share price rise is often based of real earnings and profits although not always.  For that reason, we believe that the technology sector and select innovators in the space will continue to benefit going forward. While the line between healthcare, biotech and strictly technology continues to blur the healthcare sector, in general healthcare continues to run higher.  We believe that the broad healthcare indices may not be the best place to be however as we see clear winners and losers over the next several years. Consistent Innovators in any industry have historically done well and now is no exception whether it be in technology, industrials, communications, hardware, or any other industry.  Contrary to popular belief, some of these companies can be found in what many consider “boring industries” but have healthy balance sheets and often provide income through dividend payments.

Looking forward:  While the next round of stimulus has yet to be decided, we expect there to be some clarity provided within the next few weeks.  Once that uncertainty has been removed, we expect the market to continue moving higher.  We could be wrong if the stimulus is perceived as too little too late but as I mentioned earlier, neither party benefits from not providing a solid stimulus bill.  Earnings have been largely positive and there have been a few surprises on both sides of the coin.  Many expected advertising revenues to move lower but were surprised when Facebook reported positive results and it was GOOG that supplied more disappointing results.  This suggests there may be more to the story as we dig deeper into the numbers.  We also continue to see a growing concentration of larger cap stocks dominating the large index funds.  This is an important fact for those who exclusively use these large well-known indexes for diversification.  The top five stocks make up nearly 22% of the S&P500.  Two of those stocks are also heavily weighted in the DJIA 30 and four of them make up nearly 42% of the NASDAQ100.  You may not be as diversified as you think by simply owning the indices.

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