Last week was every bit as traumatizing economically as we expected. Yet, somehow, markets were mildly phased and have since marched higher, perplexing many experts by the complete disconnect between market valuations and the economy. We were informed Consumer Confidence is again trending lower, we learned our Fed Chairman's economic outlook is grim at best - borderline doomsday - and we found out our economic output fell by nearly 35%, the largest quarterly drop on record. And yet the market just keeps moving higher. How??
The stock market acts as a discounting mechanism for the value of future expected earnings of the stocks of the companies that make up the market. The expectations of future earnings vary, which is why some stocks may "break out" when they outperform those expectations. The market can quickly analyze and revalue stock prices based on new information. Or so we believe. The old sayings that the market “climbs the Wall of Worry” or “looks across the valley” might be pertinent to remember here. However…the reason the current market environment is so perplexing is that all of the new information we're getting is pointing at a catastrophic economic event, which would reduce corporate earnings, and therefore "should" drive stock prices lower. In other words, we're looking at a BIG valley!
During Fed Chairman Powell's press conference last week he made it clear he believes the government stimulus had a positive impact on the economy, at least temporarily, and it appears as though investors believe the Fed can "keep this thing between the ditches." However, let's examine that for a moment. The Federal Government quickly passed programs no one understands and provided the largest stimulus package in Keynesian history, and the economy still contracted by nearly 35%. While better than the initial 52% decrease estimated by the Atlanta Fed, it's still 35%. In normal conditions, we would assume a significant reduction in corporate earnings would follow. Less money flow in the system means lower earnings, and companies have been informing investors that the next 6, 12, 18, maybe 24 months will probably be very challenging. However, much of the market is being propped up by big tech, consumer goods, and digital entertainment industries. So, what we believe to be a good market is just the fact that indexes are weighted, and the companies that make up a significant portion of the weight happen to be the ones carrying the entire market right now.
Another factor that is likely to be playing into this divergence between economic data and market valuations is the current record-low interest rates - literally the lowest in modern history. With the 10-year treasury around .50%, an investor isn't even keeping pace with inflation. Therefore, many will likely put their capital to work elsewhere, even though in a normal environment we would see money flow into the perceived safety of fixed-income assets.
We've also seen gold prices explode, which is typical when there are expectations of inflation or a weakening currency (essentially the same thing). As the Fed continues to print money, at what traditional currency principles would call unsustainable, the expectation for inflation grows in many economic circles. Therefore, the fear of being overexposed to cash may be prudent. We have seen flows into the historical "inflation hedge," but gold as an asset class is anything but "safe." With a standard deviation nearly 60% greater than the S&P 500 index, those looking for "safety" might want to consider other options.
This could play out in a multitude of ways. We know that as money flow continues to slow, we will see people reconsider how they utilize their personal capital. The economic impact effects those at or below the median wage significantly more than those above. As unemployment continues to climb, median wages fall. That could lead to flows out of the market as people may take money out of investments to pay for living expenses. The Fed and lawmakers may have the ability to completely avoid what appears to be the beginnings of an economic meltdown, although they've yet to demonstrate that level of control in their 108 year history. Additionally, is that the role of the Fed? Should it be?? In the meantime, we have seen some of the smartest, most successful investors give compelling reasons for why they're searching for safety in the current environment. Eventually, those investors tend to be right (and by "tend to be right" I mean, they've yet to be wrong). Will this be the time they're wrong? Will retail investors finally outperform "smart money" by remaining overly optimistic and staying invested when all the data says, put on your seat belt, it's 'bout to get bumpy?
Keep checking back here for insights and information on the markets and economy. We hope you'll join us on Friday for Donuts On-the-Line, a Facebook Live event we host every other Friday. We'll continue talking about these topics with more colorful explanations from Don and Keith. If you can't make the Live session, there will be a replay. As always, we hope you're staying safe, and finding as much joy in this wild season as you can.