Elephants in the Pool

To state the obvious, we are living in very difficult times. At the six-month mark of the pandemic, we are all anxious to get back to some level of normalcy.

Forest fires rage throughout the West filling the air with so much acrid smoke that we can see it here in Michigan on a clear day.  There have been so many named storms this year, the World Meteorological Organization started using Greek letters for the big storms in the Atlantic.  The last, and only other time this happened was in 2005 when megastorms Wilma, Katrina, Rita, and Emily struck the US.  Protests continue to fester, and while the overwhelming majority of them have been peaceful, the violence that has occurred has been unfortunate and unsettling.  The nation also mourns the loss of the trailblazing, universally respected Supreme Court Justice Ginsburg.  All this is the backdrop of a particularly acrimonious political environment in which we find ourselves as Election Day approaches.Despite all this, the major sports leagues were desperate to test the water of our new normal and resume play. To do so, they established numerous safety protocols, even extreme ones such as isolating players at Disney World and competing in empty arenas.   During football games, the league now uses artificial intelligence to create crowd noise for television; even fans have been outsourced.  Sadly, they might need to tweak their AI program to add more booing to my beloved Lions games.  As much as the world has changed, we still have the same old Lions.  Fortunately, the financial markets have performed better than the Lions; the broad US indexes returned to where they started the year after posting a strong third quarter.

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Averages can be deceiving. You wouldn’t jump into a pool if you didn’t know how to swim just because the average depth is only four feet deep. Better to understand what’s beneath the surface of your point of entry. The deep end of the stock market consists of the top five stocks which are pulling the averages way higher and obscuring what is going on in the rest of the pool. The S&P 500 is a market capitalization weighted index. This means that the performance of larger companies always has a greater influence on movements in the index. However, the weight of the top five stocks right now is unprecedented. The accompanying chart (taken from a Wall Street Journal article and put together by the BofA Global Investment Strategy group) highlights this well. The last time the top five stocks were even close to this level was in the waning days of the tech bubble.

Today, these five stocks are worth nearly $7.0 trillion. To put that number in perspective, our nation’s Gross Domestic Product is about $20.0 trillion. During the pandemic, investors have sought safety, and these five stocks represent safety. Their revenues and earnings continue to grow, benefiting from more people working from home, while most of the nation struggles. Their stocks climbed a collective 40% this year. The median return for the other 495 stocks in the S&P 500 is -8%! That’s quite a disparity. International stocks did about as poorly as the median S&P 500 stock, and small to mid-cap stocks fell even more.

This sets up an investing dilemma. While we are in pandemic mode, these companies will continue to grow their earnings, and the average company will continue to struggle. However, the pandemic will end. The stock market usually anticipates economic changes six to nine months in advance. We’re getting close to the point where the market will start thinking about what happens after the pandemic – though this timing does assume some of the vaccines currently in the late trial stages will be successful. Will the government continue to support a very weak economy after the vaccines come out? How much permanent damage will the pandemic cause? Will working from home continue after we get the all clear sign? Will there be a rotation out of these big growth names into other parts of the market?

A quick review of the top five stocks from the tech bubble may provide some clues. To put it mildly, they did not fare well in the decade after the bubble burst. Only Walmart, the least techie of the bunch, eked out a return during the next decade, growing a total of just 11%. The median stock rose 52%. The S&P 500 fell about 6% brought down by the performance of the other big four which fell between 32% and 66% during that time. There was a massive rotation out of the big growth names and into the other parts of the market.

While the current environment has the same feel as the late 90s, there are some differences that make an exact comparison difficult.

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First, the valuations are not nearly as stretched as they were back then. The big five today have a Price/Earnings (PE) ratio of 40. That means, for every dollar of current earnings, investors will pay $40 to own the shares of the company. For context, the market usually has a PE ratio in the 15-22 range. So, 40 is high, but not nearly as high as the 45-65 multiples the top five had back in 2000, and Cisco’s PE ratio was well over 100. Also, interest rates are materially lower today with the 10-year treasury rate below 1% vs 6% in March, 2000. Low interest rates support higher valuations in stocks because lower rates provide less incentive to hold treasuries.

Another key difference is the experience of these companies. Back then, newer technologies could and did come out to supplant the existing technology. It was tough for a company to hold its market lead while also expanding its base. The giants today have figured out how to maintain their virtual monopolies while also expanding into new markets. Remember, Amazon used to be just a bookstore. Apple just sold computers. Now, they are entire ecosystems unto themselves. The antitrust laws are decades behind where they need to be.

On the other hand, growing a $2.0 trillion company at rates high enough to justify a premium multiple is difficult. When you become a significant part of the economy, as these five companies are, it is difficult to grow much faster than the economy you now represent. Also, politicians on both sides of the aisle are looking into the market power of the top five companies.

Some antitrust measures can be expected in the next four years regardless of who wins the presidential and congressional elections.

At this point, it is a bit too early to completely sell off the large growth names that have been the engines of the market. Taking a little off the top seems prudent, and starting the rotation into the rest of the market should reward investors over the long-haul. Maintaining exposure to overseas stocks will help if and when the rotation begins as well. This also diversifies the portfolio away from the dollar which could be vulnerable considering the amount of debt we are taking on as a nation to offset the forced shut-downs. With interest rates as low as they are, gold too has a place in the portfolio. Unfortunately, unlike in the late 90s and early 2000s, fixed income returns are paltry and should only be used to lower the overall volatility of the portfolio. Just as it’s important to work to maintain personal equilibrium during these crazy times, your investment portfolio also needs to remain balanced to be healthy. We’ll keep looking under the surface with a critical eye on the elephants in the deep end for any signs they are ready to move in a different direction.

Sincerely,

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Anthony J. DiGiovanni, CFA

Stranger Things

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The Netflix mini-series Stranger Things has nothing on reality. To recap the year so far, we are battling through a global pandemic unlike any in the past 100 years. The novel coronavirus is highly contagious and extremely dangerous, particularly to the elderly, those with pre-existing health conditions, and those without easy access to our healthcare system. To counter this deadly virus, all fifty states issued some form of stay-at-home order creating a self-induced economic coma. In just the past quarter, we’ve seen negative oil prices (see Free Oil, by Michael Molitor on our website), an increase in the number of countries issuing debt with negative interest rates, massive anti-racist protests throughout the country including one in which a six square block section of a city was taken over by protestors, hand-to-hand combat on the border between China and India, and North Korea antagonizing South Korea by blowing up a building. Also in the category of “strange,” Hertz, a company in bankruptcy, rallied 400%, and then decided to try to issue new stock because of the rally. To be fair, its disclosure statement did say it is highly likely this new equity would be worthless (caveat emptor to the extreme). The stock market responded to all this news by rebounding with a vengeance. The most common question we have received over the last couple of months is, “How is that possible given all of the uncertainties (and oddities) we’re facing today?”

The very short, simplified answer is the shear financial power of our government. The speed with which the pandemic hit our markets was matched by the speed with which our government responded (as shocking as that might sound). Congress passed numerous stimulus bills costing several trillion dollars and the Federal Reserve pumped in several trillion dollars more. It used every trick ever learned from past financial crises and added a few new ones. The dollar amount of the stimulus projected through the end of the year will end up totaling approximately 20% of our nation’s Gross Domestic Product (GDP), a staggering amount with most of that money literally created out of thin air.

This aided the stock market on several fronts. First, this money went directly to those most affected by the pandemic. Unlike during the Great Recession when the stimulus money went through the banking system, this money went directly to taxpayers and business owners with the goal of keeping wage earners afloat. The government incentivized business owners to hold onto their employees. Despite this, there were massive layoffs and furloughs as the economy came to a screeching halt. The government also approved more unemployment benefits (with a bonus $600/week) than in past recessions. 75% of those who applied received benefits. Normally, only about 25% get them. This allowed most people to continue to pay their bills and minimized damage to businesses (companies in the stock market).

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One other possible reason for the surprising rebound during a pandemic is a bit more troublesome. Schwab reported that during the first quarter, they opened a record 609,000 new retail client accounts. Relative newcomer, Robinhood, signed over 3 million new clients. The combination of no commissions, a stimulus check, no sports to bet on, and a lot of free time has perhaps contributed to a retail investor boom in the stock market. The total effect of this is difficult to gauge, but the Hertz example mentioned above highlights why this might be dangerous if this is indeed a major contributor to the rally. Contacts in the brokerage industry have mentioned that a lot of these accounts are starting with $1,200 or $2,400 values, the exact amount of the stimulus checks received early in the quarter.

 

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Secondly, the Fed provided a great deal of liquidity to markets that were not functioning well during the initial panic from the first quarter. They propped up prices by buying the bonds of companies. This kept companies’ borrowing costs down and prevented marketplace panic forcing unnecessary bankruptcies. Thirdly, the Fed cut interest rates on short-term bonds to near zero. Long-term bonds followed suit with the 30-year bond dropping below 1% at one point. This has an indirect effect on the stock market. Treasury bonds represent the risk-free investment option. When the expected rate of return drops to essentially nothing, investors look elsewhere. Many of those dollars flowed back into the stock market, thus forming some semblance of equilibrium between these two markets.

So now what? An extremely wide range of possible outcomes exists for the next 18 months. We use scenario analysis to help us position portfolios in times like these. As you might expect, the progression of the virus and our government’s response to it will drive all these scenarios. Our base case suggests the virus will not be under control until a vaccine comes out. The fastest this could happen, with enough of us vaccinated to have a meaningful effect, is some time in mid- to late 2021. Past experience with pandemics predicts a second wave is highly likely by the end of this year. We are already seeing cases rise now that most states have reopened to some degree. What will happen in the fall when children possibly return to school and colder temperatures drive people indoors?

In this base case, our economy stays in recession, or at best a near zero-growth environment for a couple of years. Earnings don’t top 2019 levels until at least 2022. Many companies with high debt levels and a high dependence on travel or hospitality will fail. Stay-at-home workers discover they do not need to go to the office as often, and this becomes a more permanent part of how our economy functions. This affects commercial buildings negatively but does have some positive side effects (lower pollution, more efficient workspaces, etc.). Our government will continue to add stimulus to the economy in an effort to keep things from completely unraveling.

A more positive scenario would involve new therapeutics coming to market. While this wouldn’t end the pandemic, it may allow more people to feel safe enough to venture back out to restaurants and travel. We have already seen improvements in patient care and outcomes, but the risk of death is still too high – especially for the most vulnerable groups. If this risk could be diminished down to a level similar to that of the flu, the worst would be behind us.

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A more negative scenario develops if the vaccines prove ineffective or dangerous. There are over 150 trials right now. We have attacked this challenge with all that modern science has to offer. This makes this scenario somewhat remote, but not impossible. This scenario would cause a great deal of financial setbacks and a prolonged recession as governments do not have an endless supply of resources.

In consideration of all of these possible scenarios, we have positioned portfolios with a higher cash balance, more gold, fewer cyclically sensitive stocks, more growth names somewhat insulated from the effects of another quarantine, and a few stronger value names that would perform well if a positive scenario develops. As the United States seems to be an epicenter of the virus, we have continued to add to our international exposure. At some point, it will make sense to add some of the riskier, badly beaten down stocks to the portfolio. Now is a bit early to implement this tactic.

Survival is paramount in this moment. This is true of your portfolio, but of even more importance is your health. Please take care of yourself and your loved ones and follow the CDC guidelines: wear a mask in public, stay six feet apart from others, and remain home as much as possible. As we try to do with your portfolio…avoid unnecessary risks. One long-time client succumbed to this disease; we grieve along with her family. Know that you are all in our thoughts and prayers during this very difficult time.

Sincerely,

Anthony J. DiGiovanni, CFA

Free Oil

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Headlines from news sources across the financial industry rushed to proclaim “Oil Trading at Negative Prices” yesterday as the May contract for WTI (West Texas Intermediate) Crude Oil traded in negative territory.  How can oil, a commodity with versatile uses, trade at negative prices?  Would a company really pay to have its product taken away?  It’s complicated.

The oil market is large and only one small part of it went negative.  Oil commodities consist of the spot market (current market prices) and the futures market (prices for a future date).  Yesterday’s negative price was only in the futures market.  There are two main types of oil:  WTI and Brent Crude.  Only WTI went negative.  Finally, futures extend far into the future.  Only the May 2020 contract went negative.  Let’s take a closer look at why.

A futures contract is a legally binding contract between a buyer and a seller to transact at an agreed upon price on a set date.  A buyer who still owns a contract at the expiration date (which was yesterday for the May contract) is contractually obligated to buy the oil at the agreed price and take delivery of it.  A buyer who does not do so is in default of the contract; the seller of the oil can sue.

In the futures market, most traders unwind their positions (sell if previously bought and buy if previously sold) prior to expiration because most participants don’t have the ability to take physical possession of large numbers of barrels of oil. Usually though, there are some oil companies who can take delivery and will buy if the price gets too low.  That did not happen yesterday.  With few people flying or driving, oil reserves are full.  Nobody had the capacity to take the physical oil, so traders were forced to close out their positions at any price, even a negative price to avoid defaulting.  It’s kind of like having an estate sale when moving.  It would be better to get $100 for your dining room table, but if no buyer comes along, it still needs to go, and you might end up paying someone $50 to take it away.

How did this happen?  In a properly functioning market, oil prices should not be negative because oil has use not only as a fuel but also as a key ingredient for countless products.  There are two main types of crude prices: WTI and Brent Crude.  Brent represents more of a worldwide price of crude since it is produced near a seaport and can be easily distributed globally.  WTI is a landlocked crude, produced in the middle of America, and can only be delivered to Cushing, Oklahoma.  Buyers of WTI must take possession of it in Cushing and then either store it or have a way to immediately ship it.  This is where the breakdown occurred.

Financial markets are constantly rebalancing themselves and engaging in price discovery.  When prices get too high, people sell, and the increased selling brings the price back to equilibrium.  The same process happens in reverse when prices fall deeply below the economic value; buyers step in and bring the price back to its proper value.  But when WTI prices fell yesterday, buyers did not step in.  It seems like it would have been a perfect opportunity to make a significant amount of money by buying at negative prices and selling the next month at positive prices.  However, to restate the key points, futures contracts are legally binding and delivery must be taken in Cushing, Oklahoma.  If there is no available storage in the area, and no transport system in place, then nobody can buy.  If nobody is buying, the sellers become desperate even to such a degree that they are willing to pay others to take the contract off their hands.  That is what we saw yesterday in the May WTI Crude futures.

The other type of oil, Brent Crude, is still trading in the $20 range, and even WTI Crude futures for June is still $15 per barrel.  The price for future WTI one year out is in the $30 range (see chart below).  So, the negative price was an aberration in the current contract that expired with too many sellers and not enough storage capacity for the buyers.  We joked about buying some oil yesterday and storing it at our vacant White Pine offices.  Unfortunately, we couldn’t figure out how to transport the 1,000 barrels one futures contract represents up to our offices, and we’re not sure all the barrels would fit.

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Last month, Russia and Saudi Arabia indicated there would be no slowdown in oil production, thus exacerbating the excess supply caused by the coronavirus pandemic halting the great majority of air travel, automobile use, cruise trips, and other economic activities that typically use oil.  As always happens with a large supply and a dearth of demand, prices dropped.  It is unlikely the world-wide Brent Crude price will go negative as there are still some places in the world to store the excess supply.  However, if demand doesn’t pick up soon, it is possible we will see a repeat of this issue when the June futures contract expires.

 

While the impact to the overall equity market is minimal, this event does provide some insight into the health of the global economy.  Oil prices and the economy often go hand in hand as oil is one of the main fuels used to generate energy.  The low prices indicate the severe lack of demand both in the US and the world.  This unusual phenomenon is a symptom of the severe disruptions we are all feeling in our daily lives.  The futures curve may indicate how long the market thinks this lack of demand will last and when the economy can begin to return to normal; the graph indicates the price of oil returns to a more typical $30 price by the end of the year.  We will continue to monitor this situation and how it affects our positions.  Meanwhile, we’ll work on reconfiguring our desks to accommodate 1,000 barrels of oil.

Navigating the Impact of COVID-19

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