Investing in a Bifurcated World

John P. Swift, CFA, CPA Chief Investment Officer
312-259-9595 or jswift@trustbenchmark.com
June 26, 2020

Market Outlook & Risk Factors

Looking at current price action, the market seems to be in weak hands in the form of retail day traders. I read one estimate that this group represents up to 40% of daily trading volume. Additionally, institutional investors caught in the “Fear-of-Missing-Out” (FOMO) trade when combined with the retail day traders make up the majority of daily trading.

While the Fed has the markets back, it thus far has only deployed a fraction of its headline firepower. The Fed’s balance sheet statistics showed that the Secondary Market Corporate Credit Facility (SMCCF) grew by $1.68 bn in the week ended June 24, to a total size of $8.7 bn (the Fed does not disclose the allocation between individual bonds and exchange traded fund purchases). The Primary Market CCF is still not operational. The maximum combined size of the primary and secondary market facilities is $750B. So, the Fed has used only 1.2% of its firepower, and that remaining 98.8% left in these facilities represents a massive amount of dry powder. As far as price support is concerned, having the Federal Reserve backing you up is like having all the Marvel Superheroes fighting on your side. And Chairman Jerome Powell is nowhere near as annoying as Robert Downey Jr.

On the banking front, The US bank stress tests were a mild negative. The Fed is capping dividends at Q2 levels and goes on to say that dividends will be “further limited to an amount based on recent earnings” (the Wall Street Journal (WSJ) says payout ratios will be calculated based on average earnings per share (EPS) from the most recent four quarters). Buybacks will stay suspended at least through Q3 (expected) and it sounds like they will not resume for some time (Q1:21 at the earliest, in my opinion). Banks will be on a much shorter leash going forward – the industry will essentially be forced to resubmit their capital plans later this year and there will be updates conducted quarterly by the Fed to determine if adjustments are needed. All that said, the industry’s cumulative capital did not come close to breaching the regulatory minimum even under the most stressed COVID scenarios. In the aggregate, our banking system is solid.

Banks spiked on Thurs in large part due to anticipation of a “better-than-feared” test result, but investors will probably get more discriminatory going forward. Banks with extremely low dividend payout ratios based on depressed earnings may become favored in the present environment. If the industry earns what the Street is modeling for 2021, any near-term capital anxiety will fade as payout ratios become quite manageable based on those forecasts.

On dividends, while they cannot go any higher than they presently stand, the Fed was vague about how far they could be cut. The document states dividends will be “limited to an amount based on recent earnings” and the WSJ says this means payout ratios cannot be greater than 100% of average quarterly profit from the most recent quarters. Most banks have payout ratios well below 100% of profits for 2020 (based on Q1 actual and forecasts for Q2-4 along with the present dividend rate), but a few are paying out more than they earn. Two banks that are not earning their dividend are ALLY Financial and Wells Fargo Bank.

I have been negative on commercial real estate (especially office space) since the start of Covid, but I saw an interesting comment from Brookfield Real Estate yesterday – they said companies are seeking out MORE office space in order to implement social distancing protocols as employees return to work. This all seems to be wishful thinking from a biased real estate developer. I am going to stick with my negative call on that sector, as working from home has been proven to save money, improve employee morale and boosts productivity.

There is no change to our market outlook (outlined in prior notes), but I concede there are some valid rumblings about an enormous bifurcation in the market as growth/momentum technology stocks become valuation agnostic and cyclical/value stocks continue to be weak. And what of the value manager’s claim of an imminent rotation into value stocks? As Donnie Brasco would say ‘Forget about it!’ All we get on the front-end of these moves into value stocks is a few head fake sessions before its back to the growth/momentum story – there is no outright selling of that growth/momentum theme.

Here is a sobering statistic on this investing in a bifurcated world theme – the NASDAQ’s market cap is 74% of the MSCI All World ex US index! At the same time, approximately 1/3 of the S&P remains in a bear market YTD. Dot-Com behavior is evident in parabolic price action, embracing bankrupt companies, ignoring financial statements, elevated valuations, high retail day trading volume with a video game approach to investing, and Barstool Sports becoming the new Bloomberg/CNBC. Global stimulus efforts have resulted in approximately 134 rate cuts around the world and fiscal stimulus to the tune of $18.4T YTD or approximately 21% of global GDP.

Growth/momentum positioning, Fear-of-Missing Out (FOMO), and the “There-is-no-alternative to stocks” (TINA) trades are blunting fundamentals. The main risk to the market right now remains Covid trends getting out of hand requiring renewed shutdowns (more on this topic later). Eventually fundamentals must justify valuations. There is also talk once again about quarter-end asset-allocation rebalancing that could also pressure stocks near term (the quarter-to-date relative performance of stocks versus bonds has been one of the highest in decades). So, that bears monitoring, but my experience around rebalancing has been one of disappointment. Even when investors express macro caution, they do not exit equities completely but instead rotate to super-cap technology stocks. Markets are ignoring headwinds and are stubbornly confident in a vaccine breakthrough by the end of 2021, if not earlier. I expect a bumpy Summer and Fall.

Presidential Election Cycle this November

I have talked about election risk among one of the risk items not priced in the market. Recent news reports suggest the November election is shaping up to be a logistical nightmare as the volume of ballots sent via the mail is expected to surge. So, absent a landslide outcome, I am growing more nervous about irregularities and the possibility it may take days or even weeks before a formal winner is declared. This can make the Florida “hanging chad” incident from the 2000 presidential election look like a picnic.

On the vaccine front, the Street is increasingly convinced the White House will force the FDA to issue emergency approval for at least one COVID vaccine before the November election. Media reports for weeks have pointed to the White House pushing hard to accelerate the “Operation Warp Speed”. Is this truly a positive if true and it happens? Do we really want politics influencing FDA approval process which can lead to ineffectual vaccines at best? The vaccine process reportedly is being accelerated so much that critical questions will not likely be answered by 11/3 or 12/31 like do the vaccines have any side-effects? Do the vaccines block infection or simply the development of symptoms? If the vaccine only blocks symptoms (but not infection), are those people then still contagious? Will the vaccine work equally in all demographic groups (i.e. will it inoculate older adults)? For how long does the immunization last? If the immunization lasts only 12 months, does that mean we will be required to be annually vaccinated? What happens if multiple vaccines are approved – how does one pick between them? The market is treating this issue as a binary event, and it seems far from that to me. If we get a rushed vaccine ahead of the election but none of the questions I have outlined have been answered, how many people are going to say, ‘sign me up’?

COVID-19 Watch

One of the major risk factors continues to be the coronavirus case count in the U.S. It had been decelerating due to conscientious efforts to stay at home, but in recent weeks case counts have been accelerating in some states as reopening plans have been embraced. We have been watching the troubling COVID trends in several large states (CA, FL, AZ,and TX), specifically. Not only are cases climbing, but hospitalizations are too. While the case numbers can be noisy given increased testing, the hospitalization data is another story. I saw a 97% ICU bed occupancy rate in one of the states yesterday, and while some tried to explain it away by saying only 27% of those beds were Covid related, I am not sure that is comforting if the Covid numbers are increasing. We are now starting to see certain state/local politicians consider behavioral/travel restrictions and companies look to modify their reopening plans. While renewed lockdowns from state governors still seem unlikely, the normalization process may very well be blunted as consumers attitudes shift. Note the recent shut-down of bars in TX and FL.

This is perhaps the market’s biggest worry right now, because it has priced in a lot of hope with respect to the reopening boost and the unleashing of pent-up demand. That is why it has not unraveled at the idea that Q2 GDP is likely to see the largest contraction in economic output on record. It’s not bothered by that, because it knows it can’t get worse than that and that Q3 GDP will inevitably show a return to stronger growth (maybe the strongest on record, albeit off a very depressed base).

No one is disputing the prospect of stronger growth in Q3 and, all else equal, a continuation of growth in Q4. The questions are, will the growth be as strong as expected in the second half of the year and will 2021 feature a return to normalcy?

The answers will depend in large part on the path of the coronavirus, the path of vaccine/treatment efforts, the path of the labor market, and the election outcome in November. Clearly there will be more fiscal stimulus well before November.

The Bottom Line

The stock market has had a strong reaction to clear signs of improvement in the broader economy and the operating performances for many companies. There has been fundamental improvement, just not to the extent that it is absolute in most instances.

The Federal Reserve and Congress have launched aggressive stimulus plans designed to shorten the recession and to enhance the recovery period. It remains to be seen what the economic uptake will be, but it will not be quick if consumers hoard their disposable income waiting for another COVID shoe to drop.

Fed Chair Powell for one thinks it will be a long road back and that the economy is going to require accommodative policy for an extended period. That view is captured in the Fed’s median projection for the fed funds rate to remain near the zero bound through 2022.

The expectation that the fed funds rate will remain unchanged through 2022, suggests economic strength in absolute terms is still a relatively long way away.

Catching Up

We look forward to catching up with each of you, and we will be reaching out to schedule a time to meet over the phone or by a Zoom/MS Teams video link. In the interim, if you would like to get something on the calendar, please send me a note with some dates and times.

Warm regards, John