Things Are Looking Up

Wishing everyone continued safety and well-being as we begin to move to the next phase of managing this pandemic through a structured restart of economic activity.

Federal, state, and local governments have drafted plans to re-open the economy, as unemployment numbers continue to increase nationally (estimates now at 20% of the labor force) and GDP numbers show the beginnings of economic contraction.

In contrast, the equity and fixed income markets have been resilient in the face of the mounting negative economic news. As we stated in our April 3rd post, we suggest separating health and economic news from the markets. It is unknown which direction markets will go short-term; however, markets have historically bottomed before the economic bottom. As the saying goes, it’s always darkest before the dawn.

Below is this weekend’s recommended reading:

Things are looking up (Scott Grannis, California Beach Pundit)

The author goes through several economic and public health charts to surmise that the future is looking much brighter than it did 30 days ago. On the economic front, confidence in the financial markets has been increasing as a result of increased liquidity. Bank lending has increased to backstop businesses going through a disruptive period. Absolute levels of debt are at historic highs, yet interest payments as a percentage of GDP remain well below historical averages. Automobile traffic is starting to increase, signaling the start of a return to somewhat normal activity.

On the public health front, the globe has seen a collective slowdown of deaths from coronavirus and the curve appears to be flattening. One interesting note, the experience in Sweden, which has not resorted to the use of mandatory lockdowns, is substantially similar to that of all other European countries and the US. The virus is running its course, with or without government lockdown. Calls for a reopening of the economy have become amplified.

An imminent economic restart would occur much quicker than recently feared and would bode well for recovery. However, there will be obvious concerns over a second wave. Time will tell as to whether this phase of the crisis is managed properly.

When You Have No Idea What Happens Next (Morgan Housel, Collaborative Fund)

The previous article is a good transition to this one. We need to be reminded no one has any idea what the future holds. Any discussion is pure speculation. As the author suggests, we must accept that assumptions about the future can be destroyed overnight. It was true before the virus. It will be true after it passes. Things change. For those who contemplate the future how fragile assumptions can be, the author recommends the following:

1. Read more history and fewer forecasts: We have stressed this previously. Researcher Philip Tetlock wrote an entire book on the failures of expert forecasts. However, history has a way of providing insight into the present. As Mark Twain famously said, “History doesn’t repeat itself but it often rhymes.”

2. Have more expectations and fewer forecasts: This is a great distinction. If you accept that certain things will happen (recessions, bear markets, etc.) without trying to predict the timing, you can develop a rational plan for action once they occur. Additionally, from an investment perspective, a portfolio can be constructed with those expectations in mind and guesswork (i.e., forecasts) can be removed from consideration.

Occam’s Razor on Interest Rates and the Stock Market (Ben Carlson, A Wealth of Common Sense)

Occam’s Razor states the simplest explanation is often the correct one. A frequent question we have received recently is the following: “How can the market rebound when the economic news is so terrible?” Of course, no one knows the real answer to this question and there are likely multiple variables at play. However, one simple and likely reason: TINA (there is no alternative).

Goldman Sachs recently published an article in which they expect, in their baseline scenario, earnings on the S&P 500 of $170/share in 2021. For sake of assumption, let’s assume this is correct (although we know how faulty forecasts can be). The S&P 500’s current level is ~2,800. So, it trades at 16.5 times projected earnings (Price/Earnings ratio). Flipping the Price/Earnings ratio around gives you Earnings/Price (called earnings yield). The earnings yield is the expected return if price or earnings do not change. So, under current assumptions by Goldman Sachs, the earnings yield for the S&P 500 is 6.0% (1 divided by 16.5). Compare that to the interest rate on the 10-year Treasury of 0.60%.

As the author suggests, maybe the equity markets have rebounded because there are not a whole lot of people (or institutions) that can survive on 60 basis points of income per year. This may or may not be the answer, however, it is a reasonable conclusion.

We hope everyone has a happy and safe weekend. Please give us a call if you have any questions.

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