📝 Market Commentary for 2020-Q2
This quarter, we've witnessed historic monetary and fiscal stimulus in response to the COVID pandemic. As a result, we've seen large movements in risk assets and weakness form in the U.S. dollar.
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We are a California-based registered investment advisor and investment thought leader, updating you on important things that we saw last quarter in global financial markets. This is a modified commentary of what we create for our clients, and you can find the original versions along with proprietary data and charts here.
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Fed action spurs rally in corporate bonds and risk assets.
(Conscious Capital Advisors)
Chart of U.S. Federal Reserve Balance sheet
Source: St. Louis Fed
As we highlighted in our last commentary, the Fed’s balance sheet has exploded during the pandemic, as the central bank purchased assets to increase financial system liquidity and mitigate the economic damage created by COVID-19. Asset purchases this year have eclipsed those of the previous years following the Global Financial Crisis in 2008, and in addition, the Fed has expanded its purchases to corporate bonds as well. As central banks implement this unprecedented monetary policy, riskier assets have been appreciating.
The Federal Reserve’s balance sheet expands and contracts over time, During the Global Financial Crisis in 2008 and the subsequent recovery, total assets jumped from $870 billion in August 2007 to $4.5 trillion in early 2015, marking a 5x expansion in the monetary base, causing riskier assets such as equities and high yield bonds to rally during this time period. While the Fed attempted to unwind its leverage in 2018 to 2019, the coronavirus pandemic required the Fed to almost double its balance sheet again to about $7 trillion at the end of the quarter, and again risk assets embarked on a moved upwards, with the S&P 500 rallying just shy of 20% in Q2 2020.
Large technology stocks dominate the U.S. public stock market capitalization.
(Conscious Capital Advisors)
Q2 2020 was distinguished by a very strong rally in stocks, particularly those in the technology sector. From a long-term strategic perspective, equities remain the only asset class with the potential to generate a substantial return, given the incredibly low yields in the bond market. This phenomenon has been aptly named “T.I.N.A.”, which stands for There Is No Alternative, and we believe it will strongly influence investor behavior going forward.
Analyzing the breadth of the market rally reveals that five stocks, Apple, Microsoft, Amazon, Google, and Facebook, have led the stock market rebound during the quarter, and now constitute 20% of the Wilshire 5000, a broad-based index tracking the U.S. equity market. While technology is certainly a major beneficiary of the pandemic “new normal”, the current index concentration seems extreme, and we believe that diversification amongst sectors remains a prudent choice. This tech stock concentration is closely tied to the next observation of this quarter.
Retail investor speculation runs rampant.
(Conscious Capital Advisors)
Q2 2020 also saw a significant increase in retail investor participation. With brokers such as Robinhood and Charles Schwab cutting the explicit cost of trading to zero, and many people are sequestered to the houses with larger amounts of savings, individual Americans have turned to speculation in the stock market as a pastime. This is no better exemplified by the rise of David Portnoy, the CEO of a sports gambling company who has become a stock trader as sporting events were canceled due to the coronavirus. Portnoy live-streams his trading sessions to millions of viewers, and watching him has been akin to a real-time example of text-book investor psychology, complete with manic-depressive swings and glorious boasts of being “better than Buffett”. Such frenzied retail activity has historically been indicative of a market top and invokes caution among professional money managers. Although the market can remain irrational for longer than one can expect, such speculative behavior has caused us to favor a more defensive approach in our portfolios going forward.
The most favored stocks of retail investors have been exactly those big technology names we discussed above, Apple, Microsoft, Amazon, Google, and Facebook, and have undoubtedly contributed to the growing tech sector concentration this quarter. Just as retail investors pile in, institutional plays hold back, and we have begun to see a breakdown in the liquidity of the stock market, suggesting future volatility ahead.
Q2 2020 stock rally fails to restore dividend-generating equities to previous levels.
(Conscious Capital Advisors)
Although we saw a powerful rally amongst equities in Q2 2020, most dividend indices posted lackluster returns relative to the S&P 500. Using SPHD as a proxy, a portfolio composed of high dividend stocks only recovered less than half of its 25% price drop. Using analytics from S&P Dow Jones can see that high dividend-paying companies are mainly concentrated in Utilities and Real Estate sectors, with some Financials and Materials companies also making distributions.
Observationally, these are companies that generally employ high amounts of financial leverage. Dividend-paying stocks also are typically companies in industries that are mature with little room for growth, largely matching the investors in them, who are typically retirees seeking income. There is an incredible demand for income in the market, and fortunately or unfortunately, the trend has been to utilize the ample liquidity provided by the Fed to increase financial leverage to clip a larger coupon, while employing financial engineering to manage risk. In many ways, people are following the example of the Federal Reserve, who as discussed above, has expanded the monetary base to an unprecedented level, to maintain their levels of income.
It is also notable the large number of major companies that have cut dividends during the first quarter to preserve capital, including Wells Fargo, Marriott, Ford, and Boeing. A dividend cut is generally a rare occasion, demonstrating how significant the coronavirus event was, as most companies carefully plan out how much they will distribute to shareholders. This action most often is a signal of a company's weakening financial position in the marketplace, as a result of declining earnings or mounting debt obligations. Depending on the specific company, a company is not growing or in an uncompetitive position could have its debt obligations could eat into the capital of the firm, which would be eventually reflected in their stock price. Some companies that are not growing and have high debt levels would become zombie companies - existing to pay their debt obligations and consuming valuable resources.
The U.S. Dollar weakens as the U.S. and China decouple.
(Conscious Capital Advisors)
Chart from Bloomberg
One of our largest investment thesis is the weakening of the U.S. Dollar in the face of a growing geopolitical rivalry between the United States and China. The coronavirus has only accelerated trends that were in play well before the pandemic occurred. This quarter, we saw hostilities increase as China passed a national security bill, effectively ending the “one party, two systems” policy in Hong Kong. The United States struck back on these developments, ending Hong Kong’s special trading status and taking measures against Chinese firms listed on U.S. stock exchanges. As the disagreement about the nature of trade between the two economic giants continues, both U.S. and China are taking steps to control the flow of capital between the countries. A harder stance on China is a rare area where Republicans and Democrats agree, and we believe that are seeing a new cold war emerge, with both risks and opportunities for financial market participants.
One area where this rivalry has been playing out is in the currency markets. While there was a flight to the dollar as a safe haven at the beginning of the pandemic, traders have sold off the preeminent reserve currency largely in favor of gold as a result of the extraordinary monetary easing by the Fed we discussed previously. It’s also notable that emerging market bonds have displayed lower than anticipated levels of distress during this crisis so far, suggesting new developments in these countries. The weakness of the dollar is a secular thesis that continues to guide the many decisions in our portfolios, with foreign assets becoming more attractive, as well as domestic companies that derive a majority of their revenues from international exports.
While it’s much too soon to call a victor of this rivalry, one thing remains certain - the world is quickly changing, and the next 10 years will be very different than the previous 10 years.
About Joseph Lu, CFA®
Joseph has over a decade of experience as an investment professional, primarily in quantitative analysis and portfolio management roles. He is the founder and managing director of Conscious Capital Advisors and a CFA® Charterholder. The CFA charter is a globally respected, graduate-level investment credential by the CFA Institute, a global association of more than 90,000 investment professionals working in over 133 countries.
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