APRIL 6, 2020 MARKET UPDATE
We hope that you are all staying healthy and managing through this very difficult time. There have been so many financial and economic headlines generated over the last few weeks that it’s almost as if we could send out a new update every day. We promise not to do that, but we do believe that enough has happened since our last email (March 17th) that now is an appropriate time to provide you with a recap of what we feel are some of the most significant developments, and more importantly how they impact the current investment and financial planning environment.
What’s happened?
The most significant policy related development over the last couple of weeks has been the passage of the CARES Act, which was signed into law on March 27th. The CARES Act provides economic stimulus, valued at over $2 trillion, in response to the coronavirus shutdown. Some of the more significant components of the bill include direct payments to tax payers, increased / extended unemployment benefits and the much needed relief to small businesses. Stocks, at least in the short-run, responded positively to the new legislation. The S&P 500 was up 10.67% for the week ending 3/27. Stocks resumed a more negative trajectory last week, although it’s certainly seemed more orderly than the extreme bouts of volatility that we saw in early March. For the year, the S&P 500 is still down over 21%, even with the strong move up two week ago. International stocks, measured by the MSCI EAFE index, are down over 25% for the year. From a distance, bonds appear to have delivered some much sought after stability during this volatile period with the Bloomberg Barclays Aggregate Bond Index up about 2.3% on a YTD basis. In an environment like we’re in, with extreme volatility in the stock market, it’s easy to almost forget about the fixed income component within a portfolio. However, we believe that the bond/fixed income component deserves more scrutiny than ever as there has been a tremendous divergence in performance between high quality bonds and lower rated / high yield bonds. For example, the Bloomberg Barclays HY Bond Index, which is comprised of bonds issued by entities that are generally worse off from a financial / solvency standpoint, has a YTD performance of (17.59%). The performance differential between high and low quality bonds clearly shows that the market is concerned about many of the lower quality issuers’ ability to make principal and interest payments moving forward as economic conditions continue to worsen.
Our View
We continue to hear many market commentators talk about a V-shaped recovery. What that essentially means is that they expect the economy (and the stock market) to bounce back quickly once the health picture has improved and the lockdowns have been lifted. We disagree with that opinion for two reasons. First, what we are experiencing is truly something that none of us have seen before. The lockdowns that have been instituted across the country have already created tremendous economic damage, and it remains unclear as to how long they will continue. We believe that turning the economy back on will not be as easy as flipping a switch. Rather, we’re concerned that the impact on business and the consumer will be longer lasting. The second reason that we disagree with the V-shaped recovery thesis, and one that we view as more foundational, is that we believe that there were significant economic issues bubbling beneath the surface as we came into 2020 that have nothing to do with the global pandemic. Don’t get us wrong, there were many strong elements of the economy, particularly in the United States, including record low unemployment, a seemingly healthy consumer (at least on the surface) and the longest bull market for stocks in history. With that said, we believe that a significant amount of growth over the last decade has been fueled by the aggressive (accommodative) policies of the Federal Reserve and other central banks around the world. Since the financial crisis of 2008-2009, the Federal Reserve has pumped over $5 trillion dollars into the banking system through the expansion of its balance sheet, thereby allowing debt levels to grow substantially at all levels including the government, businesses and consumers. The Fed has also artificially held interest rates very low over the last 12 years. The rate that the fed controls directly, the fed funds rate, has been at the zero bound level for the majority of that time. Artificially suppressing interest rates, or the cost of money, over a long period of time can have a very negative effect. One of the greatest economists of our time, Thomas Sowell, stated in his book, Basic Economics, that “Making anything artificially cheap usually means that it will be wasted, whatever that thing might be and wherever it might be located.” The Fed, by making the cost of money / loans “artificially cheap” and flooding the system with liquidity has enabled bad economic behavior and encouraged excessive risk taking to take place over the last 10+ years. This excess has shown up in many different areas throughout our economy.
One, that has gotten a lot of media attention in the last few weeks, comes in the form of corporations buying back their shares in the open market. Corporate buybacks, if used responsibly, can be a very useful tool as part of a capital allocation strategy assuming that a company is able to buy back its shares at a price deemed to be significantly below fair value. On the other hand, there is certainly the potential for abuse if buybacks are used simply as a way to boost stock prices and reward executives. Apple, Inc. provides a great example of how a share buyback program can impact a company’s stock price. In FY 2015, Apple (AAPL) recorded EBITDA (operating earnings) of ~$77.13 billion. In FY 19, APPL recorded EBITDA of $74.54 billion, representing a 3% reduction over the 4-year span. Earnings per share, on the other hand, grew by almost 30% over that same period from $9.22 to $11.89. How could EPS grow by 30% when Apple actually made less money? Simple, from 2015 to 2019 AAPL bought back roughly 20% of their shares outstanding. Less shares means that there are more earnings PER SHARE, even when overall income has gone down. The result has been explosive growth in AAPL’s share price of 179% through 12/31/2019. In Apple’s case, they had the cash to buy back 20% of their shares and still have plenty of liquidity left over. Many other companies have engaged in a similar practice over the last 10 years, but instead of having the cash on hand, they’ve had to issue debt to borrow the money. Right or wrong, that practice has fueled a large part of the stock market’s growth in recent years and the availability of cheap money has exasperated the issue.
Another area where the Fed’s policies have encouraged excessive risk taking in recent years is with regard to public pension plans. Pension plans do a calculation every year to determine how much new money needs to be added to ensure that the plan can meet its liabilities (payments to covered participants). One of the main variables that goes into that calculation is an assumption as to the rate of return that the plan can earn on its investments over time. Historically, a good portion of pension plan assets were invested in relatively safe bond type investments. However, with the suppression of interest rates in recent years, pensions have not been able to achieve the rate of return that they need actuarially in traditional interest bearing investments to satisfy their rate of return calculation. That has resulted in the plans “reaching” for yield and taking more risk than would otherwise be the case. In fact, a WSJ article on March 6th stated that public pensions came into this year with the highest allocation to stocks that they’ve had in the last 13 years. Just in time for a significant drawdown. Many public pensions were significantly underfunded coming into this period. It would seem obvious, given the higher level of investment risk they’ve taken, that the funding status is going to get a lot worse which will ultimately put added pressure on states and municipalities.
These are just two of the many examples of how monetary policy carried out under the guise of “stimulating the economy” can cause significant structural problems. The important point to note is that these issues existed before the coronavirus pandemic occurred, and they will still be with us (and probably much worse) after the health concerns begin to dissipate. Therefore, we do not believe that we are likely to see the V-shaped snap back that many prognosticators have called for. It is for that reason that we intend to maintain the cautious stance that we’ve had for well over year with regard to our investment strategy and the markets. We remain vigilant and ready to assist you no matter what the future may hold.
As always, we appreciate the confidence that you have placed in us as your trusted advisor and we welcome your questions at any time.
Important Disclaimer
JPS Financial, LLC is registered as an investment adviser with the Securities and Exchange Commission and only transacts business in states where it is properly notice filed or excluded or exempted from such filing requirements. Registration as an investment adviser does not constitute an endorsement of the firm by securities regulators nor does it indicate that the adviser has attained a particular level of skill or ability.
Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors on the date of publication and are subject to change. The information presented does not involve the rendering of personalized investment advice and should not be construed as an offer to buy or sell, or a solicitation of any offer to buy or sell the securities discussed. All investment strategies have the potential for profit or loss.
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