Hi folks. Brett Girard, Portfolio Manager at Liberty here for another market update.
As we enter the second full week of May, the S&P 500 is staying around 2,900. This is about 15% lower than the peak in February and about 33% higher than the most recent market bottom in March. To get back to those February highs, we need to see another 17% rise.
Now, all said, we’ve had quite the run over the last seven weeks. The big question you might be asking is, why? It’s a very good question, and to answer that, we have to go back to the basics on what stock represents.
When purchasing a stock—which is really an ownership stake in a business—you’re buying claim to all future gains and losses of the company. The keyword there is future. Imagine investing in a stock—or more broadly, in a stock market—sort of like driving in a coal-fired, steam-powered train. The future is visible, but only at the front windshield, and you’re stuck on the tracks with only the ability to speed up or slow down. And to successfully operate the train due to its size and weight, you must look well into the future so that you can react in advance of when you need to. You don’t want to drive too fast because you run the risk of coming off the rails, but you also don’t want to drive too slow because you run the risk of the weight of the train overcoming the power of the engine and causing it to stop.
This current health and economic crisis could very much cause the train to stop. But the market’s focused on three things, all of which are positive and giving the impression that we’ll be able to maintain speed going forward.
The first thing is fiscal and monetary stimulus. By effectively taking interest rates to zero and lending money to corporations of all sizes, the governments of the world have—in a very coordinated fashion—shoveled coal into the engines of the train. It’s unclear how much coal the train is carrying, and therefore how much more stimulus is possible. But the market’s pricing that the stimulus will avoid partisan issues and continue until it’s no longer required. Think of this more like enough coal to power the train and to maintain our current speed.
The second force propelling the train is the reopening of the economy. Now, shelter in place orders are being lifted around the world. In China, parts of Europe, and even in certain US states. With that, there’s a wave of hope akin to a tailwind pushing the train. The market is pricing that regions around the world will continue to reopen, and behaviors will revert to pre-lockdown patterns. That means that people will fly on planes, people will eat out, and purchasing habits will not change fundamentally from February. In other words, the tailwinds pushing the trains will continue.
The third force propelling the train is that some sort of COVID-19 treatment or vaccine is just around the corner. There are currently almost 100 clinical trials in the US alone of some of the brightest minds in medicine and science toiling away. A development in this area would be significant for the economy and the markets. You can think of this as a sort of change in the pitch of the tracks, where the train can now head downhill with gravity’s help. It’s a lot easier to travel on the train in that case.
Now, this all sounds great, but we have to remember that trains, unlike cars or planes, are stuck on the tracks with only the ability to speed up and slow down. That means that any obstacles in the way, hazards, cannot be avoided.
From where we sit at Liberty, there are three big hazards related to the rosie view just presented.
First of all, regarding the Federal Government Stimulus, we want to know what happens if it slows too quickly or just stops outright. With respect to monetary stimulus, while lower interest rates appears to be the new norm, the Federal Reserve has already made monetary policy changes by scaling back open market operations. This is a signal to the market that the stimulus is not intended to exist in perpetuity.
Our eyes run the fiscal stimulus, not only for the large and small businesses but also for the furloughed or the laid-off individuals. With reports of people making more money by staying home and collecting government checks than they were while they were working, we wonder how the train is going to keep chugging if the stimulus (or the coal in this case) stops being shoveled into the furnace.
Now, if you’ll permit, I’ll mix metaphors for a second. The stimulus represents life support for a very sick person. It helps keep them alive by supporting their breathing and by administering fluids. But what happens to a sick person when they come off life support? Will they able to function on their own? Will the economy? If recent history is any indication, just think back to 2018 (specifically in the fall) when the Federal Reserve attempted to increase interest rates. We all remember the S&P fell by 20% during the last three months of the year. Is that what we have to look forward to?
In terms of reopening, significant economic damage has already been done. Over the weekend, the University of Chicago released a paper estimating that 42% of businesses (most of them were small businesses) won’t be able to reopen once the economy does. Unemployment in the US increased by 20 million people in April alone, and there’s expectations that the unemployment rate could eclipse 20% during May.
Here at home, we’ve lost about 3 million jobs, and the Canadian unemployment rate as of the end of April sits at 13%. Now, some of these job losses will be temporary, but as we reopen, we’ll have to contend with the reality that certain people will have permanently lost their jobs.
Across the board, we’re seeing savings rates increase as people are more focused on saving for rainy day funds than consumption. And really, I don’t think this is being talked about enough; just because a business reopens doesn’t mean those scared will be willing to go out in public. When you step back and consider that 70% of economic activities predicated on consumer spending, reopening won’t get us very far unless individuals have the funds and the desire to spend. This could be a significant headwind for our train for years to come as job creation does not happen overnight.
While much is being done in terms of researching a treatment and a vaccine for the virus, the truth is we have a long way to go. Medical experts throughout the world are working on the hypothesis that the earliest we could potentially see a breakthrough is 2021.
In the meantime, we’re concerned about a second wave of COVID erasing the gains we’ve made in flattening the curve. Not that the Spanish Flu of 1918 is a perfect analog, but death rates were far higher during the fall of that year, which coincided with a second wave after a relatively mild summer. This is a hill that the train must climb, and it’s going to take great time and energy to reach the apex.
So, you might be asking, what are we doing at Liberty? Well, our activities could be summed up in two words: we’re observing, and we’re preparing.
The equities that you hold were selected based on the strength of their balance sheet, the ability of their companies to generate free cash flow, and the aptitude of their management teams. It’s in times like these—in these economic stressful times—when we see how well strong companies can perform. We’ve always shied away from the cyclical travel, restaurant, and energy stocks because our goal is to consistently grow free cash flow over time, not do so in booms and busts.
Consider yourself: while you might be deferring the trip around the world or not filling up your car with gas, we’ll hazard a guess that you’re still continuing to purchase your soap (from a company like Unilever), taking your prescriptions (maybe Novo Nordisk), and staying connected through your cell phone (like at Tellus). Some things won’t change, and that’s why we’re happy with the equity holdings.
In some portfolios, to maintain proper asset mix, we’ve selectively made purchases on the fixed income side. Both corporate bonds and preferred shares issued by high-quality companies have been snapped up as institutional players a step behind are just now trying to raise cash.
Finally, the cash balance that you’ve had in your accounts since 2018 is still there. It will remain until your stock holdings hit our pre-determined prices. This is anywhere from 40-60% below where we are currently trading, as mentioned in the newsletter. Ultimately, equity valuations are very rich from a historical perspective, so we are patiently waiting.
While each week of shelter in place feels like a month or even a year, we’re only ten weeks into this recession. And if history is any indication, that means another 20 months on these tracks before the economy recovers.
As always, please feel free to reach out to David, Annie, or myself for any questions. We’re always around to chat. Thank you for watching, and please take care.