The Economy Is Not The Stock Market

So here we are….in the middle of a global pandemic. Unemployment in the US is hovering around 15%. Businesses are struggling to remain viable. Hundreds of thousands of families…probably millions …are concerned they won’t be able to make their mortgage payments.

Yet, the stock market is closing in on all time highs set earlier this year.

How is that possible? What gives?

The party line answers sound something like:

“Stocks prices reflect future earnings, not present earnings”
“COVID-19 is temporary, and our economy will return as soon as it passes”
“The market is just being manipulated by the Fed. All that cash is pumping up the market”

All these are reasonable responses. But they circumvent a very important concept that many of us seem to be forgetting recently:

The economy is not the stock market, and the stock market is not the economy.

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Reflections on the Pandemic So Far

We are currently somewhere around day 60 of our family’s quarantine, and the country is inching closer to reopening. Over those 60(ish) days I worked remotely from home, and held a TON of meetings with clients, colleagues, and others over Zoom. As you can imagine, everyone has handled the last two months a little differently. Some investors are more comfortable with volatility than others.

I had a chance this week to think back on the sentiment in general. How people are doing and feeling. How they’ve handled the last few months. What their financial situation is like right now. And while everyone has handled quarantine and the Coronavirus pandemic differently, there are some trends I’ve noticed across many of my conversations. I thought these trends might make an interesting blog post, so here are a few things that have been on my mind recently.

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Market Update: Q1 2020

Well here we are….one quarter into 2020, and the risk event we’ve all been waiting for has finally arrived. Volatility as measured by the VIX Index touched all time highs over the first quarter as the Coronavirus spread from China to Italy and the rest of the world.

The stock slide here in the United States was fierce, but a late quarter bounce regained a substantial portion of the lost ground. More ground, in my opinion, than the numbers really support.

From here, small cap and emerging markets are starting to look like wonderful bargains. But without knowing the extent of the economic damage & how long the world will be sheltering in place, it’s difficult to make that argument with too much confidence.

Here’s this quarter’s market update.

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The CARES Act: Implications for Individuals

As I’ve written about on the blog and covered on the podcast recently, the CARES Act is a big piece of legislation. (Remember….the total package is $2.2 trillion!). We’ve covered several sections of the bill and how it might impact you on the blog recently, including a deep dive into the paycheck protection program.

There are also many provisions in the bill we haven’t covered. Specifically, sections relating to stimulus checks, expanded unemployment insurance, mandatory distribution holidays, penalty free retirement account withdrawals, and student loan relief. Coincidentally, all have been commanding a large number of questions from clients of Three Oaks recently.

Like all legislation there is a great deal of gray area in this piece of legislation, especially given the urgency with which it was passed. The IRS, SBA, Department of Labor, and other government entities are scrambling to provide relevant guidance as soon as possible. So while there may appear to be some planning opportunities with regard to the law, it’s entirely possible they’re just a temporary mirage. Nevertheless, here’s what we know now about the CARES Act and how it might impact you as a taxpayer.

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Where Do We Go From Here? Market Thoughts & The Risk of Financial De-Leveraging

Well that escalated quickly. We are now officially in the second fastest bear market on record. Bear markets become official when stocks fall 20% or more from their peaks. Ordinarily this takes months to play out. Bad news comes out, stocks sell off a bit. Everyone goes home, thinks about it, and comes back the next morning. More bad news comes out, stocks fall a bit further, and so on. Here’s some data from Marketwatch on how long it typically takes to enter a bear market:

With the Coronavirus driving the U.S. and much of the world to shelter in place, our economy has come to a screeching halt. Some forecasters are guessing that we’ll see a 5% drop in GDP this quarter, others are predicting as much as a 30% drop.

Whatever camp you reside in, the picture is not pretty. Markets did not take long to notice. Whereas it takes on average 136-137 trading days to enter a bear market based on the data above, it only took us 19 to get there this time – the second fastest on record:

So where do we go from here? A stimulus package is just about to be passed (finally). Markets rebounded as much as 12% yesterday and another 4.5% today. Even though the public health picture still looks bleak, we are starting to wrap our heads around how long the pandemic may continue.

Here are a few things I’m reading and my thoughts on what happens next.

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Coronavirus is Spreading…..Markets are Plunging…..Is it Time to Panic?

**Update: I wrote this draft on Saturday, and since then oil has dropped 30%, circuit breakers for the U.S. stock market fired this morning, and the 10-year U.S. bond yield has fallen below 0.5%. The charts and numbers you see here are as of Friday. My stance has not changed.

What do the following have in common?

U.S. marginal tax rates are too low
Central banks printing money will lead to asset bubbles
Washington partisanship
Political turmoil with Russia, the Middle East, or North Korea
Trade war with China

These are the risks that could derail the decade long bull market and business cycle we’ve enjoyed since 2009, according to market pundits. Viral contagion? Nowhere to be found.

At this point there are over 100,000 cases of Coronavirus across the world, with 400 being here in the U.S. While the media has certainly fanned the flames of panic, COVID-19 will have a substantial negative impact on the global economy. The best epidemiologists in the world are forecasting that 40%-70% of the world’s population will contract the virus. People are beginning to cancel flights & vacations. Small businesses are scrambling to put together “work from home” contingency plans. All of which will be a drag on the economy.

The markets have…taken notice. After a tumultuous few weeks, the S&P 500 is now down 8% on the year and investors around the world have flocked to safe havens like long term U.S. treasury bonds.

Here’s the return of TLT, a 20+ year U.S. government bond ETF over the last week and YTD.

TLT: 20+ Year US Bond ETF YTD Weekly Returns

The Coronavirus is Spreading....Is it Time to Panic?

Source: Kwanti

TLT: 20+ Year US Bond ETF YTD Returns

Source: Kwanti

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Market Update: Q4 2019

Picture what you were doing on January 1st of 2019. Maybe you were getting an early start on your fitness goals for the year. Maybe you were up early, ready to take in some New Year’s day football. Maybe you were in bed all day nursing a hangover.

If I were to ask you what you thought the stock market would do in 2019, what would you have said?

Would you have guessed that 2019 was the year that the 10-year bull market finally came to and end? Would you have said you had no idea?

What I’m guessing you wouldn’t have said was that the S&P 500 would be up 30% on the year, tossing market bears aside like leftover confetti from the night before. At least I wouldn’t have.

Yet here we are, about one year later, and that’s exactly what happened. And not only did the S&P climb 30% on the year, it did so in extremely steady fashion. This was true in the fourth quarter of 2019, just as it was in the first three.

Could this be the year that the bull market wanes? Read on for more details and background.

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Cash is King: Competitive Pressures in the Brokerage Industry & How to Get a Decent Yield

If you’ve been paying attention to financial headlines or the brokerage industry at all, you may know that competitive pressures have been heating up recently. Last year Charles Schwab announced it was reducing commission rates for stock trades to $0, hoping to capture market share and thwart momentum from upstart firms like Robinhood. Oh, and once the pressure on competitors began to sink in, Schwab purchased TD Ameritrade.

Since then more chips have begun to fall. Vanguard and Fidelity both decided to follow suit and reduce their own commissions to $0. As the brokerage industry continues to mature, I’m certain we’ll see more changes that benefit investors. In the meantime, you may be asking how these brokerage firms are even able to offer trading for free. Isn’t that how they make money? How can brokerages be profitable when they don’t charge anyone for trading?

Over the last decade or so brokerage firms have transitioned steadily away from commission revenue and toward net interest margin. Just like a bank, the idle cash sitting in your investment accounts is reinvested by your broker.

You don’t see this, of course. All we see as investors is the paltry monthly interest that accumulates in our accounts. But just like a bank your brokerage firm is taking that cash, reinvesting it in various bonds, collecting somewhere between 3%-5% per year, and paying you a fraction of that.

Is this a nefarious activity? Absolutely not. But it does mean that brokerage firms have a major incentive to suppress the interest paid to everyday investors. And with equity market valuations stretching further and the business cycle growing more gray hairs, it’s becoming more important to command an adequate yield on our cash.

This post will cover how you can go about it.

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Is Index Investing Really a Bubble?

Back in September, Bloomberg published an article about index investing that made a few waves. If you read the book or watched the movie “The Big Short”, you might remember Michael Burry. He’s the former doctor turned hedge fund manager who lives in Silicon Valley (and rocks out to death metal in his office while pondering investment strategy).

The article made waves because Burry claims that index investing is a massive bubble. Comparing index funds to CDOs (collateralized debt obligations), Burry’s perspective stoked fear in the hearts of more than a few investors. Here’s the guy who correctly identified one of the biggest bubbles and upcoming crashes of all time. And he’s saying that index investing could be a bubble too? Maybe the simplicity we’ve enjoyed of investing in index funds was really a big mistake. What if he’s right?

Don’t run for the hills just yet. There’s been some great discussion of whether the argument is fair (here, here, and here, for example). Here’s my take on whether index investing really is a bubble.

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I Keep Hearing We’re Nearing a Recession. Are We Nearing a Recession?

There’s been more than a few news headlines recently claiming that we’re on the verge of an economic recession. For many business owners and investors the word recession is a lot like Voldemort. It’s so evil and scary that you’re not even supposed to say it. “Recession” evokes fears of falling stock prices, unemployment, and scarcity.

So what exactly is a recession? And should we treat them with the same respect that Harry Potter treats Lord Voldemort?

Recessions are technically two or more consecutive quarters where national gross domestic product contracts. Gross domestic product (GDP) is sum of all the goods and services a country produces. It’s the broadest and most common way to measure economic activity and the strength of the economy. Growing GDP is a good sign, falling GDP is a bad sign. This is what US GDP growth has looked like since 1930. Lots of major swings between 1930 and 1950, and relatively steady since about 1985. Note that by that time the US dollar was the world’s reserve currency, we were off the gold standard, and interest rates had started to stabilize after stagflation in the 1970s.

Now on to why you should care. The more goods and services a country produces, the better off its citizens are financially. There’s more wealth being created, more jobs available, and usually faster rising wages. For businesses this means that your customers have more stable employment and more discretionary income to buy your products.

In a recession GDP contracts. There’s less economic activity. From a business’s perspective your customers have fewer jobs, lower wages, and less discretionary income. Revenue dries up, and you may be forced to lay employees off yourself. Times are tough.

From an investor’s perspective, recessions are tough on asset prices. The value of your stock holdings, including index funds, depends on the market’s expectation of future cash flows & profitability. Recessions are tough on cash flow, tough on profitability, and tough on stock prices. Recessions often coincide with bear markets.

So where are we now? Are we actually nearing a recession, or is the rhetoric we’re hearing on the news just propaganda? I’m no economist, but I do have some background and stay informed as part of my day job. Here’s my take on whether we’re nearing a recession.

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