The behavior of the stock market has been a great puzzle to most observers lately. Why is the market surging when the economy is still struggling, unemployment is still high, earnings have sunk, and the pandemic still rages?
Stock values are substantially pinned to forward prospects and interest rates, not what is happening today. (Note I say “substantially” – that’s because certain events, like the attack on the World Trade Center and the early shutdowns due to the pandemic cause the market’s viewpoint to shorten momentarily; that’s when you get that sinking feeling…. )
Interest rates are benign at the moment, boosting stock values. A simple way to think about this is in terms of dividend yields. The average dividend in the stock market today is somewhere close to 2%. But the long Treasury yields less than that. Some investors will prefer the higher cash flow, even with increased risk, on stocks. Dividends do go up over time, too. The more complicated answer is that a formula called the dividend discount model shows that stock values increase when bond yields decline.
Aside from the math, another reason stocks are rising is because companies are cutting expenses right and left. When people return to whatever purchasing becomes normal after the pandemic, new sales revenue will go nearly straight to the bottom line, generating much higher cash flows and profits in out years. Investors are looking forward to those improved earnings streams. And that is what’s causing today’s prices to ignore today’s economic fallout.
The coronavirus pandemic has caused a surge in borrowing, at governments, companies, and households. Of these three, the numbers at the government level are the most spectacular – generating giant deficits all over the world.
Most of us grew up with the notion that large budget deficits are bad. At first, we believed that budget deficits caused inflation. Then we believed that they caused slow growth. Either of these may be true; or both may be true, depending on how the rest of the economic landscape looks. Amid this uncertainty, there is one thing we CAN say: budget deficits are costing us less in this low interest rate environment. We looked at Treasury financings for every year from 2015 through the first four months of 2020. In the 2020 time frame, new borrowings are costing us less than 1% per year. Rates were low in 2015, but during later years, we typically paid twice as much on longer bonds, and slightly more than 1% on bills. Furthermore, every month, older bonds on which we paid high rates are maturing and being refinanced at much lower rates. The public is benefiting much like you might if you refinanced your home loan from 3.75% to 2.75%.
As of May 2020, the average interest rate on all US debt – new and outstanding – had broken below 2% for the first time ever, putting the brakes on overall interest expenditures.
So while budget deficits are alarming, low rates are not only a benefit for current borrowings, we are also saving money on old debt. Some of that can reverse if rates rise from here, but a portion of our debt is in fact financed longer term, where savings will last for years. So if there was ever a good time for the US government to borrow, now is it.
Bonus fact: while we may worry we owe a lot of debt to China, that country’s holdings of US debt are just 5% of total outstanding debt. Japan owns slightly more, and the UK sits at third place. By far the majority of US debt is owned by Americans or our government itself.
We interrupt our series on ESG to bring you perspectives on the virus overtaking our news, the markets and our lives. Following is a compendium of what we know:
- Scientists are working on vaccines and treatments feverishly, but there is much that is not yet known about this disease. For instance, we still don’t know how long the virus is viable on a surface and we still don’t know if people who have been infected become immune. While computer modeling can come up with likely treatment candidates relatively quickly, it’s the trials process that is slow, so we’re looking at a year anyway before a vaccine can be in use.
- Mortality numbers are varying dramatically by approach to containment, testing, medical facilities available, and demographics. While Italy’s numbers are scary, and so are Washington state’s, most deaths in both places by far have been in elderly populations and both populations are under-tested. The average age of mortality from the virus in Italy is around 81. Even in China, mortality in Wuhan was much higher than in the rest of the country. Widespread use of currently available tests will diminish the fatal case percentages; recently China has developed a blood test to see if citizens had the virus but were asymptomatic. Obviously if thousands of people contracted the virus but had no symptoms, that will also change the statistics.
- There are signs that China is getting back to work, which is good for the global economy, but there are also signs that it’s taking a long time for folks to normalize routines. While it’s dangerous to generalize too much, a “V” shaped recovery may not be in the cards, but there’s also no doubt that a near full stop of certain activities will probably result in pent up demand. People might be eager to go out to eat after quarantine, but not yet brave enough to buy a car or take a trip.
- The infection has come on so quickly that we have not seen enough data to gauge the impact of all the moves to quarantine, impose social distance, test, etc on the global economy. Too, government data is reported with a lag. Economic numbers due out in the next few days will not be meaningful in the context of what’s happened in late February and early March.
- The markets – both stocks and bonds – are struggling to adjust for the risk of a big downside to the economy. However, prices are also impacted significantly by selling that happens when fund managers have bets that don’t work out. For instance, if a hedge fund is short the long US Treasury which has skyrocketed in price, it has to cover that trade, which might mean selling some completely unrelated item in its portfolio, such as gold. This is why we have seen nonsensical moves lately, where despite tanking stock prices, bonds and gold also go down in value. Banks are using the Treasury market as collateral, and as risk rises, their trades cause prices to go haywire. These ancillary effects help explain why prices ‘waterfall’ downward during bad times. Apple moving from $325 to $250 is partly because fewer phones will be sold, but also because it is a liquid asset that can be sold by someone in trouble. Apple has not suddenly become a bad company.
- Signs of a market bottom include the following: The Dow doesn’t close at the lowest level of the day; we don’t close at the lowest level of the day on a Friday in particular (traders are afraid of weekend news in bad times, when they can’t trade); the news is still awful but stocks rally. These are signs of exhausted sellers, particularly the last one.
As always, give us a call with questions or concerns.
The latest trend in investing is ESG. ESG stands for Environmental, Social and Governance. About 25% of every investing dollar these days is going to ESG strategies. More than just a version of socially responsible investing, ESG is a broader look at capital allocation, with the aim of making investments to better the world. ESG is still evolving, but it has made a big impact on companies already. Most companies, especially larger ones, publish detailed sustainability reports now, making it simpler to evaluate their impact on the world. That said, because ESG is so popular, companies have an incentive to emphasize the positives and hide the negatives. Meanwhile, there are not yet any industry standards for evaluating ESG factors; instead multiple ranking firms have cropped up, publishing ESG ‘scores’ for hundreds of companies.
ESG has attracted hundreds of investment advisors who offer it as a product, partially because with the market so hot over the trend, fees can be significantly higher. Furthermore, to clients asking for ESG, performance is less important. They want to follow a set of values as a primary consideration. The perfect product is shaping up – fees can be high but demands for performance are soft.
Heretofore, ESG has relied heavily on technology companies, which are considered to be more green and diverse than, say, industrial companies. When the market is carried upward by tech stocks, as it has been for about ten years, ESG strategies perform well. However, the jury is out about whether ESG produces incremental performance over simply buying a low cost index fund. The trend is simply too new to evaluate – not enough data is available.
In our next installment, we’re going to take a look at a few specific companies and their ESG reports, using those as a springboard to talk about the philosophies behind ESG.
The stock market has declined over 10% due to fears over the economic impacts of Covid 19, aka the new coronavirus. While that number isn’t such a severe reaction – we were down 20% just as recently as the fourth quarter of 2018 – what’s been more interesting is the swiftness off the decline.
The markets have changed dramatically in the last decade, with index funds and ETF (exchange traded funds) providing a much more potent impact on trading. Fast trading, trading by algorithm, and leverage against positions to enhance returns on the upside are all more common today than just ten years ago. Information moves faster, and regulations dictating how and when companies must disclose information have encouraged that. These factors mean that downtrends move faster, finish faster, and may even reverse faster.
If we look at today’s situation, with the Covid 19 virus circulating, there is no question that the virus will deliver an economic slowdown. However, after that slowing, we think pent up demand will cause above trend growth. The question is, how bad will things be, before the market begins to look forward to the rebound?
No one knows the answer to that, but it is tied to the spread of the disease and the number of new cases in countries other than China – where new cases are abating and people are getting back to work albeit slowly. A vaccine will likely emerge in 18 months or so, which we would expect to provide a boost to risk assets. If a compound such as Gilead’s remdesivir proves effective against symptoms, then the rebound could arrive faster. Furthermore, bond interest rates have plunged. Consider that the ten year Treasury now carries a yield only slightly higher than 1% now. Is it possible to fund retirement plans at 1%? The answer is no. In fact, a majority of S&P stocks carry dividend yields higher than that now. Eventually, folks will need to go back to funding retirement plans in a sensible way, and that’s not going to be by using a bond that yields only 1%.
At extremes such as we face now, doing less is better than doing more. This is not a great time for a wholesale allocation change, so try to refrain. But keep this moment in mind the next time you feel frisky about how well your stocks are performing!