By: Cliff Hodge, CFA, MBA – Chief Investment Officer
3 Phases of the Economy
“There are decades where nothing happens, and there are weeks where decades happen.” – Vladimir Lenin
While I try not to make a habit of quoting infamous communist dictators, few quotes if any embody the spirit of our world midway through 2020 more than this one does. We are only a few weeks into the new decade, but already many tumultuous events have transpired that will undoubtedly change the course of human history. COVID-19 has affected the life and health of billions around the world. Our hearts go out to individuals and families that have had to deal with infections and saying goodbye to loved ones. For the first time in history, the global economy stopped. Tens of thousands of businesses have closed and millions have lost their livelihoods. If a global pandemic weren’t enough, 2020 has also brought on mass protests at home and abroad. Fortunately, the violence and looting which accompanied the more peaceful demonstrations have eased, but it is evident that there are serious rifts among the populace.
There is little doubt that 2020 will be a watershed year. Our thesis for the economy and markets is that since the outbreak of COVID-19, the US economy has undergone two phases, and is on the precipice of transitioning to a third. We describe these as:
We will dive into the specifics below, but if our thinking is correct, the economy and the markets are not yet out of the woods from a risk perspective. There remains an ongoing bullish bias that continues to support the market near-term, driven by an unprecedented stimulus, the reopening of the economy, and hopes of a vaccine. Stock markets are back near the highs while the real economy remains in a world of hurt. So far 2020 has been the year of the Great Disconnect. Bull markets built on “momentum” and speculation can last longer than logic would predict. The risk comes when investors ignore the warning signs and go all-in in a speculative frenzy like we’re seeing today. It is usually just about then the inevitable correction occurs. Such is the inherent risk of ignoring risk.
Review:
As always, to understand the present and to provide context for our thoughts for the future, it is helpful to review the past. We came into 2020 with our models forecasting what we refer to as a Quad 3 environment, which is an economic regime where growth slows year-over-year, while inflation accelerates. For a brief review of our macroeconomic framework which guides our short and intermediate-term decision making, review the graphic below.
Source: Factset
Coming into the new year, our equity portfolios were positioned relatively defensively compared to the broader equity markets. Our models indicated that the most likely path for the economy was to continue to slow before ultimately resulting in a recession likely in 2021. Our view was a bit more pessimistic than consensus Wall Street estimates at the time, which forecasted rising economic growth, corporate earnings and market returns as far as the eye could see (as they typically always do.) At the time our exposure was split between some growth areas in the market, including Technology exposure alongside more defensive sectors such as Utilities.
The onset of the coronavirus aka COVID-19 changed all that. We began tracking the spread of the virus in late-January and early-February as a potential Black Swan event. The term Black Swan is defined as an event in human history that was unprecedented and unexpected at the point in time it occurred, but in hindsight appears as bound to have happened. The term originates from the discovery of a species of black swans in Australia when prevailing knowledge at the time was that all swans were white. (For more information about other black swan events visit http://blackswanevents.org/) While we will be the first to admit that the scope of what COVID-19 would ultimately become exceeded our expectations, our conviction in our defensive stance was increased by the market signaling aspect of our investment process. Many of the indicators we track, turned lower well before the equity markets ultimately rolled over. Some of these included: sharp drops in Treasury yields and commodity prices, strength in the US dollar, rising volatility and strength in risk-off sectors of the equity market. This gave us confidence that the market would pull forward a Quad 4 environment, where both growth and inflation slow simultaneously and highlights the importance of our data-driven investment process.
Historically Quad 4 is the worst environment for equity markets, and this year followed the playbook closely. The S&P 500 fell more than 35% from its all-time high in late-February before bottoming in March as the global economy was forcibly shut down by governments across the globe.
Source: Factset
What followed next was an unprecedented amount of stimulus, both monetary (from global central banks led by our Federal Reserve), and fiscal (from federal governments.) In the US, our Fed cut interest rates to 0 and unleashed the printing presses increasing the size of their balance sheet by over $3T in the span of a few weeks. Moreover, the Fed continued further unprecedented action by announcing provisions to buy investment grade and high yield (aka junk) bonds for the first time ever, dwarfing what was done even during the aftermath of the 08-09 Global Financial Crisis.
Source: St. Louis Fed FRED database
Not to be outdone on the fiscal side, the Federal Government passed the CARES act, a $2.2T stimulus program aimed at Main Street by offering forgivable loans (Payroll Protection Plan i.e. PPP), enhanced unemployment benefits, and direct payments of $1200 for those who qualified. These actions, along with Wall Street’s ever-optimistic V-shape recovery narrative, and marginal improvements in month-over-month economic data have caused markets to surge higher and as of this writing are only a few percentage points away from pre-COVID all-time highs. All the while, over 54M Americans have filed Initial Jobless claims for unemployment over the past 19 weeks, over 30M Americans continue to draw on government benefits, and thousands of businesses across the country have shuttered, in many cases permanently. Equity markets have become extremely disconnected from economic reality. We know that the stock market cannot remain detached from fundamentals indefinitely. Throughout history it is not the fundamentals that play catch-up to the market, but the opposite. The only question is when?
Path forward:
We view the economy so far as having undergone two broad phases. The first phase (ie the Shutdown), seen during March and April, was comprised of data that was extremely negative in the rate of change terms. In May, we began transitioning to Phase 2 (the Bounce), which we believe will last into July and early August, as the economy starts to reopen. As expected, during Phase 2 we have seen data that exhibit positivity in rates of change terms month-over-month when compared to the very depressed prior data. As discussed previously, this data, while positive, does not justify the historic move
in risk assets. We believe that the economy is about to enter a third phase, however (Recession); where we expect to see a prolonged business cycle downturn, perpetuated by a strongly negative credit cycle with negative underlying inventory, CapEx, labor and profit cycles that will take time and space to work out.
Markets are extremely overvalued on just about every metric that we track. Since we typically review the Price to Earnings (P/E) ratio on our webinars, I thought we’d look at a different valuation metric. Below is a chart of the Total Market Cap to GDP ratio, which divides the total market capitalization of the Wilshire 5000 by US GDP. Otherwise known as the Buffett indicator, since it is billionaire-investor Warren Buffett’s favorite valuation metric, this ratio is nearing 155%, the highest reading on record.
Source: Factset
From a portfolio perspective, we have begun to position for an economic transition back to Quad 3, where growth remains slow, but inflation stabilizes and moves higher. The barbell approach that we have talked about previously, combining some areas of growth with some more defensive positioning is typically what works well in this macro environment. The chart below looks at the expected return and the hit rate (percentage of time quarterly returns are positive) for the S&P 500 looking back at 20 years of data. As we can see the backdrop for a Quad 3 environment has not been especially attractive for overall market returns. Combining the historical risk/return precedent along with the fundamental factors of extreme over-valuation in tandem with the depressionary economic picture and election risks on the horizon, there are a tremendous number of things that can go wrong in the weeks and months ahead. We don’t know and can’t know which factor will cause the market’s mean reversion, but when it happens, as it did in March, it will take many by surprise and the damage could be consequential. As such, we continue to maintain additional cash and focus on high-quality in our investment portfolios. If these warning signs do come to fruition, then a more conservative stance in portfolios will protect capital in the short-term. If not, it is a simple process to reallocate back into equity risk accordingly.
Source: Factset
Our primary goals as your investment and risk manager are to protect your hard-earned capital and compound growth in a prudent way to help you reach your long-term goals, whatever those may be. On the investment team, we do this by focusing on a repeatable, data-driven, and dispassionate process using both market history and high-frequency economic data to position our portfolios for the highest probability market environment. While we will never get every investment decision right, we are confident that our process can have our investors positioned for whatever may come. We are grateful for the opportunity to come to work for you every single day.
Disclosures:
Investment advisory services offered through Cornerstone Wealth Group, LLC dba Cornerstone Wealth an SEC registered investment adviser. Securities offered through Mutual Securities, Inc. Member FINRA/SIPC. Cornerstone Wealth Group, LLC dba Cornerstone Wealth is not affiliated with Mutual Securities, Inc.
This material provided by Cornerstone Wealth Group is for informational purposes only. It is not intended to serve as personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment. Any securities mentioned herein are not to be taken as advice or recommendation to buy or sell a specific security. The information provided may not be applicable to your account managed by Cornerstone Wealth Group. Please contact Cornerstone Wealth Group for specific information regarding the holdings and trading activity of your account. Additionally, you should review and consider any recent market news. All expressions of opinion are subject to change without notice in reaction to shifting market or other conditions. Data provided is believed to be accurate, but its accuracy, completeness or reliability cannot be guaranteed.
To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
Risk Considerations: The economic forecasts set forth in this presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Stock investing involves risk including loss of principal. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
Any opinions made during this presentation are those of Cornerstone’s Investment Committee and Cliff Hodge and may change at any time.
All materials herein are taken from third party sources and believed to be accurate.