The Risk of Taking Less Risk
SCG Commentary June 2020
Dear Friends,
Optimism over the economic recovery from coronavirus, with all 50 states taking steps to reopen, has sent stocks higher in recent weeks.
In early May, we made a bold reallocation in your portfolios, reducing stock exposure by roughly 50% from its previous level. This is a defensive move that is designed to protect from future losses during unprecedented economic circumstances and uncertainty.
A huge number of Americans are unemployed, with the unemployment rate at one of the highest levels that it has been in our history. The vast majority of small businesses were shuttered closed for two months and it will take months or longer for businesses to get back to operating at a capacity that resembles pre-crisis levels. Some are estimating that many will never be able to reopen due to the lost revenue. Similarly, large Fortune 500 companies continue to operate at only a fraction of their capacity. How can they possibly be as profitable as they were 6 months ago? There is no data yet to determine how deep the damage actually is. And yet, for the last few weeks, the stock market has continued to march higher.
While the economic data is horrible, it is important to note that there are some ‘green shoots’ developing that point to the possibility that the worst may be behind us. Airport traffic is improving (albeit from a very low base), gas sales are increasing which indicates more movement and activity, and last week, we got some job numbers that showed a large number of people returning to work after claiming unemployment. These are good signs, and as optimists, we are happy to see that. For us, where we differ is the anticipation of how long it takes to get back to ‘normal’. Currently, the market is pricing in a completely normal economy and corporate profits landscape in 2021. To us, that just seems too optimistic and gives us pause.
One of the biggest questions we are getting is regarding the disconnect between the stock market and the economy. There are a few reasons we can identify as possible reasons for this disconnect:
1. The most common refrain is that the market is ‘forward-looking’ and looks ahead 6-18 months, which means that it is essentially disregarding the terrible economic data that we are currently seeing. There is also the widespread belief that a large number of the job losses seen are temporary and will come back as soon as things reopen.
2. We also need to remember that the composition of the stock markets does not necessarily reflect the composition of the economy. As an example, most job losses at this stage have been in the service sector (restaurants, leisure, travel etc). While the job losses are very real from a human and economy perspective, these sectors actually make up a pretty small portion of the stock market that are dominated by sectors that have not seen widespread job losses.
3. The FED has arguably played the biggest role in the recovery. They acted swiftly, with unprecedented stimulus, which has played a major role in the market recovery. With no sign of the FED stopping support, this will continue to be a major factor in the markets ability to hold onto these gains.
4. This crisis has clearly separated the ‘winners’ from the ‘losers’ in terms of the stock market sectors and individual companies. Think about the impact of shutdowns on a tech company that does everything online, versus an airline or restaurant chain. In the case of the tech company for example, this pandemic has not just spared some companies, but has actually helped. The difference between the winners and losers is stark, which is why we have observed such a huge divergence in the performance of certain sectors over others.
Recently, Goldman Sachs analysts said the rally over the past two months was unlikely to persist. And yet, it has. The S&P 500 has rebounded more than 40% since its March 23rd low and now trades basically even with the levels at the start of the year. The rally, after stocks plunged 34% in just 23 trading days is a welcome relief since most investors hold high levels of stocks in their portfolios. At a point, however, we need to ask ourselves whether the optimism reflected in the markets potentially opens the markets to some disappointment if things don’t go quite as smoothly as expected.
In an interview with the financial times Manolo Falco, Citigroup’s co-head of investment banking, said that he believes that the firm’s corporate clients should raise as much cash as possible before the reality of the pandemic sinks in for investors. “As the second quarter comes along and we start seeing the pain, and the collateral effects of the virus, we think this is going to be much tougher than it looks.” Falco estimated. We share his view.
Separately, brief hopes that U.S.-China trade tensions may subside appear to have been dashed. Investors had breathed a sigh of relief when President Trump chose not to mention sanctions or tariffs at a press conference on May 29th about China’s new security law in Hong Kong. However, Beijing is set to pause purchases of certain U.S. products, including soybeans, according to reports. If trade tensions continue to rise, I would expect market optimism to diminish, as it does not appear as if this risk is priced into the market.
In many ways, the current markets remind me of our experience during the tech bubble in the very late 1990’s and into 2000. Volatility and large single day market moves up and down became a frequent occurrence. The chart below shows that the same is happening today. In the first 5 months of 2020, the S&P 500 index has experienced a plus or minus 3% or greater daily move one out of every 4 trading days. This is 9X more volatile than its 20-year average volatility. In this environment of extreme volatility, investors will benefit from peace of mind due to lower equity exposure and we will focus on income-oriented strategies to provide a consistent source of cash flow to get us through these volatile times.
A second similarity to the late 1990’s tech bubble is the very high concentration and narrow breadth of the market. Take a look at this chart looking at concentration:
As illustrated in this chart, the five largest stocks in the S&P 500 now account for 20% of its total market cap, exceeding the 18% concentration level reached during the dot-com bubble. Those stocks are all tech stocks that you would know: Microsoft, Apple, Amazon, Alphabet (Google), and Facebook.
The next chart illustrates what we mean by narrow breadth:
In the chart above, the blue line shows the path of the S&P 500 index. A very sharp fall, followed by a very sharp rally. The red line below indicates market breadth, through the ‘advance/decline line’. This line goes up when more company stocks in the S&P 500 are going up rather than going down, and falls when more stocks are going down than are going up.
The dispersion in returns is clear: While the S&P 500 index is just off its record high reached in February, the median stock is still well below its high. While this narrow breadth could last for extended periods, past episodes of narrow breadth were followed by below-average market returns, and eventually momentum reversed.
It is a useful tool to see whether the market is being dominated by just a small handful of stocks, which we believe to be the case right now. To see a sustainable trend upwards in the market, we would need to see a steeper rise in the red line, indicating that the rally is spreading to a greater number of stocks in the market.
We have always said that our primary role is that of risk-management. In other words, helping our clients to understand when to play offense and when to play defense. We continue to believe that wealth is made and kept over decades through avoiding large losses of principal, and that if you do not lose as much in the bad times, you don’t have to make as much in the good times to end up at much the same place.
In investing, there are broadly 2 main risks: 1) The risk of loss and 2) the risk of missed opportunity. Investors need to balance these 2 risks carefully. Being too aggressive can mean large losses, and being too conservative can lead to missed opportunities. In simple terms, investors need to consistently be looking at the market and economic environment from a perspective of potential risk versus reward. In times when potential reward outweighs risk, that may be a time to play offense, in an attempt to generate returns. However, there are other times when the risks seem to outweigh the rewards. We believe that this is one of those times, and it is in those times that defense is warranted.
If the market is ‘right’ and the economy and earnings do have a quick, ‘V-shaped’ recovery, then it is likely to merely validate the current levels, versus drive the markets substantially higher. It would appear to us, however, that the reward (significant further upside) is likely to be less than the risk (potential market drops if things don’t go well), which is significant.
In conclusion:
Coronavirus, China Trade Tensions, Non-existent earnings data or economic data regarding the impact of the shutdown and most recently and unrest caused by legitimate protesting leading to rioting and looting are the reasons that we are temporarily taking a very conservative approach to investing in stocks at the present time. In the late 1990’s the market marched higher and higher based on “irrational exuberance” as coined by former FED Chairman, Alan Greenspan. Those who reduced exposure to high flying tech companies underperformed for a while but avoided the carnage of an 80% drop in the NASDAQ when the stark reality of earnings was recognized.
One of the research sources that we read daily made this statement on June 4. “None of us can tell the future. But, to be buying stocks at these levels, you are essentially saying all of the following will happen between now and year end:
• No second wave of coronavirus infections between now and January.
• A rapid economic rebound that essentially has the economy back to January levels of activity (which was the best growth we’ve seen in decades) by the end of the year.
• Republicans keep the White House and that the election is less divisive than expected.
• No major upsets in Congress or the House.
• The U.S.-China trade truce remains intact.
• Unemployment falls back to late-2019/early 2020 levels.
We would add the following expectations:
· Consumers rapidly re-engage in pre-virus activity, going to restaurants, stores and events.
· All small and large businesses operate at the high efficiency levels that they were functioning at in 2019, but somehow do it with extensive restrictions and guidelines to meet CDC and state requirements. Efficiency/productivity translates to profitability.
To be clear, all that could happen. But it’s important for investors to understand that’s what they are “buying” when they are chasing this market higher.
It can be hard emotionally to take a defensive stance, while the market marches higher due to the Fear of Missing Out (FOMO). We may be early in our timing of reducing equity exposure, but at least for now, we would rather be safe than sorry. It is important to note that we do not see this as a permanent reduction of equity exposure, and we plan to begin to increase equities at the appropriate time. We view this as a temporary cautious position while the tradeoff between risk and return appears poor, and uncertainty about the future remains extremely high. The potential for lagging performance in the short-term is the ‘risk of taking less risk’.
I am personally investing with the same conservative posture that Simmons Capital Group has taken in my private investment accounts. If you are concerned about ‘missing out’ on returns if the market continues to rise, please call us and we will work to rebalance your accounts back to a more aggressive posture.
This month we will be moving roughly 1/3 of our cash into higher yielding investments. In July, we will reassess the economy and markets and make additional adjustments as we seek to preserve, but also grow your investments.
Thank you, as always, for your continued trust, we do not take it lightly.