Cognitive Dissonance

Posted on Jul 24, 2020 in Economics

Cognitive Dissonance

The S&P 500 continues to grind higher, and it is now just 3.5% away from the all-time high posted in February. As is usually the case with bull markets, good news is being embraced while bad news is being summarily dismissed. I’ll start with the bad. The obvious bit of discouraging news has been the resurgence of COVID-19 cases in several states, primarily in the Sun Belt. As cases continue to rise, we are getting reports of equipment shortages and dwindling hospital capacity in certain areas, and regrettably, deaths are again rising above 1,000 Americans lost each day.

From an economic standpoint, the question now becomes whether or not the surge in new cases will lead to further business shutdowns, more layoffs, and a continued unwillingness on the part of the consumer to go out and spend money. The initial economic surge that began in late April is losing momentum.

It’s clear that many small businesses, which provide about half of private-sector employment, are in dire straits. Without additional funding in the form of a fourth federal assistance bill, the virus’ resurgence could be the death knell for many of these vital job providers. Thursday morning we learned that initial jobless claims rose by over 100,000 in the week ending on July 18 to 1.416 million. This was the first increase since March. Is this curve beginning to inflect upward again? Maybe not, but there is a lot riding on the negotiations in Washington, DC.

We’re also getting negative news reports regarding our deteriorating relationship with China. These developments shouldn’t come as a huge surprise as we are in an election year and both candidates want to appear as the “tougher” on China. But China is still the third-largest economy on earth (assuming the EU countries are one economy), and many American companies still depend on China as an important link in their supply chains. Many large, multinational US companies also view China as a large and fast-growing export market. Will the election-year squabbles throw a wrench into President Trump’s trade agreement with China or reduce the odds of a more comprehensive second trade agreement? The outcome is unclear, but certainly the current rhetoric does not bode well for the prospects of mutually beneficial competition and economic growth.


What’s the good news? There’s quite a bit of it actually. For starters, we’ve received positive reports about several high-profile vaccine candidates. These reports are raising the expectation that one could get approved by the end of the year, which would be quite fast based on historical precedents. We are also getting indications that leadership at the national and state levels is finally beginning to take efforts to minimize the spread of COVID-19 more seriously. This week President Trump departed from earlier statements that the virus would suddenly disappear and provided a more sobering assessment. He said that things will probably get worse before they get better. Recognition of the problem is the first step. The president also started to do daily press briefings again, and in his first appearance he took the opportunity to encourage the use of masks, push for more testing and discourage reckless behavior in public.

Thursday morning we learned that the White House and Senate Republicans have reached an agreement in principle on the terms of a fourth aid bill (although by Friday morning, the agreement appears to be shakier than first thought.) The issue had been in doubt as recently as Monday when the president was insisting on a cut in the payroll tax (which didn’t make it in). While there is still some heavy lifting ahead, it seems pretty clear that both parties are highly motivated to get badly needed cash out to struggling businesses, consumers, health care facilities and state governments, among others. It appears as though the next phase will be worth something over $1 trillion but under $2 trillion. The president has also signaled his willingness to do another round if necessary. The bill will come due one day, but for now there is too much at stake to tighten the purse strings.

We also received news that EU leaders agreed to raise 750 million euros as a common entity – the first time they have agreed to do so. This news effectively means that all 27 EU countries will be the issuer of the debt and therefore all 27 countries are on the hook for paying the money back. The significance of this development is profound. Ever since the inception of the EU there have been naysayers who claimed the EU experiment would not work without common fiscal policy. Well, now the toothpaste is out of the tube, and this new tool is likely to speed the process of recovery for the second-largest economy on earth.

There is also reason to believe that stocks, as much as they have risen in a relatively short period of time, should have some valuation support. Any stock-market bull will tell you that stocks aren’t expensive when you consider that the opportunities to make money elsewhere are quite scarce. Bonds, savings accounts, CDs and the like offer almost no return due to the low level of interest rates. And thanks to the slack in the economy (high unemployment, low factory utilization) and the Fed’s commitment to keep interest rates low indefinitely in support of the economy, the opportunities to earn a return on fixed-income investments are likely to remain scarce. We refer to this environment as TINA, or “There Is No Alternative” to stocks. One way to measure TINA is to take the inverse of the market’s P/E ratio, called the earnings yield, and compare that to the yield on the 10-year Treasury bond, for example. The S&P 500 is currently trading at about 20x the consensus estimate for 2021 earnings. The inverse of that number, the earnings yield, is about 5%, which is far higher than we can earn in the bond market (without an inordinate amount of risk).

For now, the good news wins the day. But questions remain. There is the question of the efficacy of any potential vaccines. We also don’t have any definitive answers on how long a vaccine might be effective and whether or not people can contract the disease a second (or third, or fourth..) time. Recent articles seem to suggest that vaccine recipients may need two doses, spaced out over time, for maximum effectiveness. We are also hearing that antibodies developed in recovered COVID-19 patients may go away after a period of time, especially for those who only experienced mild symptoms. For those who experienced severe symptoms, there is evidence that ongoing complications due to damage done by the virus may be more debilitating, and longer-lasting, than first thought. Are these just the meanderings of a paranoid investment manager or is this pandemic going to have economic consequences even after a vaccine is  approved and administered? The economic crisis we find ourselves  in is a result of the public health crisis. Until the latter is solved, the former will remain with us. And right now, there is simply much about COVID we still do not know.

We’re happy to be participating in such a strong and relentless rally. After Thursday’s moderate sell-off, the S&P 500 is just about 5% away from its all-time high, and the Nasdaq is already in record territory. Which brings me to my final point. This market rally is deceptive. We see daily articles now talking about how dependent this rally has been on the five largest stocks in the S&P 500 (FB, AMZN, GOOG, MSFT and AAPL). Such narrow “breadth”, which Goldman Sachs says is at 20-year highs, can be a warning sign that a correction may be near. Why? Because if some fundamental or other factor causes one or more of these mammoth stocks to falter, it could be very difficult for the overall market to maintain its lofty heights.

I’ll leave you with an excerpt from a Goldman Sachs research note published this morning and a chart from a research report by BCA Research, also published this morning. The latter shows the performance of the aforementioned largest five stocks in the S&P 500 along with the performance of the other 495 stocks in the index.

“The record degree of concentration in the US equity market has continued to rise. FB, AMZN, AAPL, MSFT, and GOOGL, the five largest US stocks, now account for 22% of S&P 500 market cap, up from 19% in January 2020 and 16% a year ago. These stocks have returned 35% YTD, compared with -5% for the remaining 495 S&P 500 stocks, and each of the five set a new record high this month.”

— David J. Kostin, Goldman Sachs.



Given the balance of risks, we remain invested but defensive. The current rally will falter, as all rallies eventually do, but may have considerably more upside until it corrects. Our investment screens include rock-solid balance sheets, no dependence on the capital markets for funding, defensible revenue streams, outstanding management, and relatively steady profitability. You will notice the list does not include “momentum.” We remain confident in the ultimate resilience of the American economy, and more importantly, the American people. This crisis will pass, and we work diligently to ensure our clients’ prosperity in the days ahead.

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