Meet the new decade, same as the old decade – only slower, and with even less inflation. That is the picture presented by the Federal Reserve at the conclusion of this week’s Federal Open Market Committee meeting, where the Fed meets periodically to discuss and implement monetary policy.

It might seem strange to think that, after all the tumultuous change the world has gone through in the past seven months, the most likely outcome for the US economy is simply more of what it was like before the pandemic. In many ways the Fed’s analysis is in line with our own economic outlook at the beginning of this year, well before the coronavirus arrived on our doorstep. The fundamental barriers to higher structural growth appear to be firmly rooted. These include: the demographics of an ageing population (lower participation rate in the labor force); persistently widening income inequality (lower rates of spending power by a larger swath of the population); the overhang of public and private debt (which has gotten exponentially worse over the course of the virus); and a global economic shift in the balance of power from the developed economies of the West to the rising ones of the East, led by China.

But the numbers only tell part of the story. While the macroeconomic trends may point to a “Groundhog Day” economy where every day is the same, the world of the 2020s will not be the world of the 2010s. Translating economic analysis into investment management requires understanding more than just the headline numbers – indeed, understanding the practical limits of what those numbers tell us.

Gentle Decline by the Numbers

Let’s take at those numbers, though. The chart below shows the year-to-year trend in real US GDP growth for the past 30 years. It encompasses the three growth cycles of the 1990s, the mid-2000s and 2010-2019, punctuated by the recessions of 2001, 2007-09 and 2020.

It is easy to see in the above chart how the pace of growth has moderated from the robust levels of the 1990s growth cycle to the relatively tepid 2.3 percent average rate of the 2010 – 2019 period (which, remember, was the longest economic recovery period on record). You can also see that the “longer run” projections by the FOMC are for growth to moderate further still to 1.9 percent. Take out the pandemic distortions – the dramatic drop in this year’s second quarter and the expected bounce-back that should occur in the year’s remaining quarters — and you are left with the gentle moderation of an ageing economy.

Every Sector is the Tech Sector

It is an economy, however, that is characterized in large part by the rapidly increasing dominance of technology. It’s already misleading to think of “technology” as something bundled up in just one of the eleven major industry sectors in the S&P 500. After all Amazon, to cite one prominent example, is not even in the tech sector. The online retail and cloud computing giant is officially part of the consumer discretionary sector. There it is just one of 60 companies listed on the blue chip index (but accounts for fully half of the sector’s market cap). Alphabet, Facebook and Netflix are also tech giants, but are part of the communications services sector alongside old-world media organizations.

Dig into just about any industry sector in fact — from consumer staples to industrials and beyond — and you will see technology at the center of the most successful business models, often anchored by cloud computing platforms on which the companies run their business operations. These, of course, are provided by the likes of a small number of tech giants led by Amazon, Alphabet and Microsoft and supported by an ecosystem of data warehousers like Snowflake (which barged into the market via an IPO this week that instantly made it three quarters the size of IBM in market cap), retail payment systems like Shopify and hosts of software offerings for predictive analytics, financial technology and everything else that makes up the “techonomy” ecosystem.

New Metrics for an Old Economy

Part of the problem economists face today – including those at the Fed – is that their traditional tools, models and metrics are increasingly out of line with the dynamics of the technology-driven economy we sketched out in the preceding paragraph. The calculation methodologies for headline measures like GDP, inflation and unemployment have not changed much since the aftermath of the Great Depression of the 1930s, when most of them were developed. In other words, we continue to use measurements today whose original purpose was to try and understand a world that existed nearly a hundred years ago – a world that very much no longer exists.

You’re going to be hearing a lot more about this from us in the coming months, because we believe that to understand where the opportunities and risks lie in investment management today is not to rely solely on models and metrics that have outlived their usefulness. What should come in their place? That in part remains to be seen. But it is worth dwelling for a second on the etymology of the word “economy” – which means “household” in the ancient Greek. We study the economy because we are trying to understand the quality of life that people – households – experience in a given time and a given place. We try to come up with useful quantitative ways to describe qualitative values.

The problems we identified above, such as ageing, income inequality and debt, are qualitative problems. A measure like GDP may give us a partial description of the problem but by no means a complete one. Meanwhile there are tens of thousands of companies out there making millions of decisions every day about how to solve some small part of those problems – in a haphazard way the usefulness (or not) of which will only emerge gradually, organically, over time. Our challenge as asset managers – as stewards of the money entrusted to our care – is to somehow make sense of all this often contradictory information and discern the structural developments we believe will be influential in the months and years ahead. It’s not easy – but it is our job and our responsibility to meet the challenge with all the tools at our disposal – old tools and new metrics alike.

It’s that time of year again. Labor Day is behind us and for investors the trickiest two months of the year are underway. September and October have delivered a bevy of surprises over the years. Many of us well recall that auspicious day in September 2008 when Lehman Brothers went bankrupt. Some of us were around to watch the stomach-churning plunge that seemed to come out of nowhere in October 1987. The Crash of ’29 is a bit more distant, but as students of economic history we have diligently studied it.

And of course today’s date reminds us of that harrowing experience to which we bore witness on a crisp Tuesday morning in September, 2001. In the days that followed the deaths in Washington DC, New York and Pennsylvania we came together in shared grief along with a renewed sense of common purpose and determination – qualities we sadly appear to have subsequently lost as a nation.

In 2020 it is fair to say we have already had enough disruption to last a lifetime – and yet there is a great deal more uncertainty that potentially lies ahead. As we talked about last week, volatility is very high in equity markets despite the vigor and duration of the rally that began in late March. Here are some of the things keeping investors up at night – and a couple possible reasons why things might not be so bad.

The Election

You’ve heard it from us hundreds of times: the market typically pays scant attention to politics. This year, though, is a glaring exception. Futures contracts on the VIX volatility index that expire in early November, around election time, are higher than they have ever been in an election season. The fear here is not really rooted in the identity of the candidates, but rather the concern that a messy election result could precipitate a constitutional crisis. If we get to December and the year 1876 is a mainstay of news headlines it will not be a good thing. In that year Rutherford Hayes and Samuel Tilden both claimed to have won the election with no clear outcome in the Electoral College. A crisis was only averted when the Republican candidate Hayes agreed to end Reconstruction by pulling Union troops out of the South (which in turn effectively ushered in the era of Jim Crow laws and enforced segregation in the South for nearly a century more). This year there are any number of things that could go wrong, too many to enumerate here. Suffice it so say that the market is hoping against hope for a clean and decisive outcome in November.

The Economy

If the worst-case scenarios did not come to bear in the aftermath of the economic lockdown this past spring, it was largely due to the passage of the $3 trillion CARES Act in March, along with the Fed’s liquidity facilities to support the Act’s different provisions for relief to households, enhanced unemployment benefits and monetary support programs for troubled businesses. Those benefits all expired more than a month ago, and Congress has not been able to get past its partisan differences to secure passage of a follow-on program. There has perhaps been a diminished sense of urgency with a series of better-than-expected jobs numbers, driven mostly by the return of workers on temporary furlough in the leisure, hospitality and retail industries.

But the number of jobs considered to be “permanently lost” has been rising throughout this period as businesses – particularly small and mid-sized ones, continue to shut down. Renters and homeowners with mortgages are delinquent on payments in increasing numbers. A hit to consumer spending will slow down the pace of recovery in GDP, which remains well below where it was before the pandemic. This in turn will affect company profits and put a spotlight back on yet another variable of uncertainty: valuations.

Stretched Valuations

The price-to-sales ratio of the S&P 500 reached a level of 2.53 times in late August, just a shade below the all-time record of 2.6 times the index attained in March 2000, at the height of the dot-com madness. Even that level does not do justice to some of the really jaw-dropping numbers you see in the high-flying tech sector. Microsoft has a P/S ratio of 12.1 times, while Tesla’s is more than 20 times. Let’s be clear here – we’re talking about sales. Not net earnings. A P/E ratio of 20 times is normally considered “expensive.” A P/S ratio of 20 – well, Tesla would practically have to have to own the entire market for electric cars for the next two decades to deliver the returns that kind of valuation implies.

We like to say that when Big Tech sneezes the market catches cold. If Big Tech catches cold the market could well come down with pneumonia. Right now the tech sector is at the center of the bumpy ride that has been September thus far. It’s not hard to imagine the conditions for a repeat of the Nifty Fifty downturn of the late 1960s, when the highest-flying names in that market led the way into the successive bust-and-boom-and-bust era of the 1970s. In a market driven by momentum, valuations don’t tend to matter. When the momentum music stops, they can matter more than anything else.

Covid-19

The virus has not gone away. In Spain the number of new cases now rivals the worst of March and April when the pandemic was in full swing in Europe. Our own new case numbers remain resolutely above 30,000 on most days, and the daily death count continues to hover around 1,000. We will have more than 200,000 fatalities within the next week or so. Medical experts are almost unified in their concern about a new outbreak as the weather gets colder and people head indoors – and the possibility for this to coincide with the flu season. The decision earlier this week to temporarily halt Phase 3 trials for one of the most promising vaccine candidates reminds us that a quick fix and return to normal life is highly unlikely.

Good Vol, Bad Vol

All these things may sound pretty bad, but that does not necessarily mean that we are in for another dramatic plunge in equity markets. Remember that volatility cuts two ways – it can go up or down. Any of the factors we mentioned above could be a catalyst for sending stock prices higher (good volatility) as well as lower (bad vol). Markets often react not so much to the substance of events as they do to outcomes relative to expectations. Take corporate earnings as an example. Many companies have reported fairly dreadful sales and profit numbers in the recent earnings season. But often those results were seen as better than what they could have been, and the stock price went up as a result. Likewise, if you watch political pundits talking about the election on any given day you come away with a picture of chaos, piles of disputed ballots, bags of unopened mail and riots in the street. It may well turn out that these and other related problems are overblown (we really, really hope that is the case).

Still worried? Don’t forget the Fed! It is more likely than not that Jay Powell and his team have a few more tricks up their sleeve if need be. Meanwhile, the best advice we can give is to stay calm, patient and disciplined. These truly are uncertain times, but we do believe it to be more likely than not that we will get through them as we always have in the past. Even if this fall does serve up more tricks than treats.

There have been three discernible phases of the bull market that roared back from the depths of the coronavirus panic back in March. The first phase was, more than anything else, a reaction to the dramatic efforts of the Federal Reserve to stabilize credit markets through the implementation of novel liquidity facilities shoring. That phase petered out in late April, and the phrases “bear market rally” and “dead cat bounce” started getting airtime. But a second phase took flight from mid-May to early June. That one fell flat as Covid cases started to rise again, once again leading to premature obituaries for the bull market. “Covid, schmovid” said Mr. Market as the Fourth of July holiday came and went, and off to the races they went yet again. Stocks roared through the sweltering days of August led, as seems to always be the case now, by the mega-cap tech darlings.

Calls, Puts and the VIX

But investors with an eye for these things noticed something unusual about this third phase of the rally. Volatility, which tends to be lower during periods of protracted stock price growth, has been conspicuously higher than is normally the case. The chart below shows one widely used measure of market volatility: the CBOE VIX index (shown here with the S&P 500).

The VIX is often called the market’s “fear gauge” because what it measures is how volatile investors expect stock prices to be in the next 30 days. The index measures this “volatility sentiment” based on the prices of put and call options. These options are essentially bets that prices will rise or fall by a certain amount; options holders profit when market prices move in such a way that the strike price – the price at which the holder can exercise her call or put – is profitable.

For example, an investor might be wild about the car company Tesla (as indeed many have been in recent weeks). The investor thinks Tesla shares are going to continue to continue to soar from their current level (around $385 currently), so he buys a call option giving him the right to purchase shares at $395. That call is not profitable today, but it would be if the share price went above $395.

How does that example have anything to do with the VIX and market volatility? It has to do with where strike prices are – for both puts and calls – relative to current market prices. For example, if call options with strike prices 10 percent higher than current market prices become more popular – measured by an increase in the price of these call options – that implies that investors expect to see market movements of that magnitude.

The same applies to puts, in the other direction (if I buy a put with a strike price 10 percent lower than the current market price it implies an expectation that prices will fall by that amount). Remember that when we talk about volatility in the market – risk, in other words – it goes in both directions. The greater the possible magnitude of deviation from current prices, whether up or down, the greater the risk.

Tradewinds and Tsunamis

In the chart above you can see that the VIX has remained higher throughout this five-month market rally than it was in the last cycle of the previous bull market from early 2019 to February of this year. In fact, the VIX for most of this time has been around the same level as it was during the previous major pullback of fall 2018, when fears over rising interest rates sent the S&P 500 to within a fraction of the 20 percent decline that would have constituted a bear market. And a big part of this higher VIX level has been an unusually high amount of option trading, particularly during that third phase of the rally in July and August.

This brings us to the next piece of the puzzle: why the sudden pullback that started yesterday and has continued into today? Nothing particularly noteworthy happened yesterday to suggest that shares in the tech-heavy Nasdaq Composite should be five percent less than they were the day before. The answer lies in the effect that increased volatility can have on the algorithmic trading programs that dominate trading volume on most days.

Think of these trading programs as waves on the ocean. On most days, the waves move in different directions as gentle tradewinds carry them hither and yon, running into each other and canceling each other out. But on some days a strong wind will blow in one direction, with the waves gathering into the force of a tsunami. Volatility is one such “strong wind” that on any given day can trigger concentrated selling, drowning out the effect of any fundamental factors (like, for instance, today’s generally benign jobs report).

The good news about this kind of a pullback is that the reasons are largely technical and have little to do with any real change in the economic outlook or corporate earnings prospects. At the same time, it is a reminder to us that we are heading into what is often a tricky time of year. Between the coronavirus, a still-fragile economy and lots of uncertainty about the forthcoming election, there are plenty of reasons to stay alert, disciplined and careful. This is definitely not a time to be asleep at the wheel.

Jackson Hole, Wyoming is by all accounts a lovely place to be in late August, with crisp late-summer skies of azure framing the inspiring cathedral spires of the Grand Tetons. Central bankers from around the world gather in this idyllic venue every year around this time for their annual confab on monetary policy. More than a few recent out-of-the box inspirations for fixing the world economy have proceeded from the clarity of mind a vigorous hike in the hills affords.

Zooming In On Inflation

Sadly for the monetary denizens of Washington DC, Frankfurt, Beijing, London, Tokyo and elsewhere, their 2020 get-together wound up suffering the same fate most of us have put up with since March, with the pleasures of tactile in-person experiences replaced by the ubiquitous rectangular screens and intermittent audio-visual freeze-outs of teleconferencing. Despite this, at least one proposed policy change came through the Zoom box that may have a meaningful impact on the economy and in particular your fixed income portfolio in the months to come. Fed Chair Jerome Powell announced that, going forward, the Fed will be using their long-standing two percent inflation benchmark as an average target. This means that inflation would be permitted to trend above two percent for a sustained period – a sort of “make-up” for all the months it has trailed the benchmark. While that may not sound like much it has profound implications, some of which have been quietly bubbling up in recent weeks in bond and currency markets as traders started placing bets on the likelihood of the Fed’s altering course.

Rising Spreads and Weak Dollar

The chart below shows two of these recent market moves. The dollar has been trending weaker against other currencies (shown here versus the euro, where an upward trend represents a stronger euro), and intermediate Treasury spreads are widening.

Now, there are a variety of factors at play here, not all of which can be attributed to anticipation of the Fed’s move. But the strength of foreign currencies versus the dollar and the widening of longer-term interest rates versus shorter-term ones both speak to the anticipated effects of inflation. All else being equal, a higher rate of inflation makes assets denominated in the inflated currency less attractive to hold. And yields on securities bearing fixed coupon payments will tend to rise as investors demand compensation for the expected loss of purchasing power they will experience as inflation eats into their nominal coupons. That will have a more pronounced effect on bonds with longer maturities. As long as the Fed keeps the Fed funds rate effectively at zero, yields on short-term bonds — which are effectively anchored to monetary policy — will stay low. Longer-dated yields, though, will rise.

If you believe the Fed can achieve what it is setting out to do – and those recent trends in the dollar and yield spreads suggest that many in those asset markets buy into the likelihood of it coming to pass – then a logical portfolio move would be to reduce exposures in intermediate and long-term Treasuries and to take on some exposure to non-dollar denominated assets like developed or emerging market equities. But there is no guarantee that this will happen. In fact we see three potential alternative outcomes, which we will set out below.

Goldilocks, Too Cold or Too Hot?

Let’s call the Fed’s target outcome the Goldilocks scenario, because economists and market pundits love that metaphor to death. This is where the Fed sets inflationary expectations a little higher than two percent – say somewhere around 2.25 – 2.5 percent, and consumer prices adjust accordingly. In this scenario the Fed can keep short-term interest rates down at their near-zero levels (maybe even putting explicit target caps on maturities out to 2 years) while letting spreads widen on longer-dated bonds. As you can see from the chart above, yields on the 10-year remain not far off their 2 year lows even after advancing in the last couple weeks. In fact those lows are historic lows, as in “entire history of 10-year bonds” low. Say the 10-year yield drifted back up to the mid-twos or even three percent? That by itself would not present much of a problem for an economy chugging along at a nice post-pandemic growth rate (which is precisely what that somewhat higher rate of inflation would imply).

What could stand in the way of that Goldilocks scenario? Well, for one thing, all the monetary stimulus the Fed poured into the economy after the last crisis, in 2008, failed to move the inflation needle even to two percent, let alone beyond that level. During this period the S&P 500 grew by leaps and bounds, but the economy itself limped along at a rate of growth well below the trend levels of previous cycles. Household earnings likewise stagnated for most income levels apart from the very highest ones. It may well be the case that, in the absence of any kind of meaningful economic realignment that encompasses a wider swath of households, things just keep on limping along as before, with GDP growth near or below two percent and an absence of the kind of pressure that would result in higher consumer prices. Interest rates across the board would stay at near-zero levels or even fall into negative territory, risk assets like stocks would mostly keep growing and the dollar would rise or fall based on how other parts of the world were dealing with things. It would be like 2017 all the time. That’s the “too cold” scenario.

Where things would really start to go off the rails, though, would be in the “too hot” case seeing the light of day. This is where all those trillions of dollars Congress and the Fed unleashed into the economy back in March (taking the US national debt level to more than 100 percent of GDP), together with still-disrupted business supply chains (possibly more expensive supply chains in an environment of de-globalization) combine to create that textbook definition of inflation – more dollars chasing fewer goods with higher input costs. Inflation doesn’t just settle benignly into a 2.25 – 2.5 percent range but maybe jumps into mid-single digit territory.

In this scenario the Fed’s easy money policy goes out the window and the whole house of cards propping up global asset markets comes tumbling down. The 40-year bull market in bonds goes into sharp reversal and equity markets experience something like the 1970s – punctuated by periodic bear markets but mostly just stagnating and producing little for investors outside of dividend payments. This scenario, in our opinion, is the one that poses the biggest risk for portfolio strategies premised on the belief that what has worked for the last decade (low domestic growth, mostly healthy corporate earnings and a permanent Fed tailwind) will work forever.

We do not think the “too hot” scenario is the most likely outcome; in fact, we think either the Goldilocks or the “too cold” alternatives both make a more compelling case in light of where the world is today. But we cannot simply wave it away, either – to do so would not be faithful to our commitment to protect the downside while seeking growth opportunities. We will continue to closely observe the market’s reaction to the Fed’s new policy and the economic developments that will give us more clues in the coming weeks and months about how it might play out.

To Our Valued Clients:

The presidential election is edging closer and speculation about the outcome will likely add another note of uncertainty to the financial markets, which have already been subjected to volatile swings caused by the pandemic, related economic pressures and global trade tensions. Regardless of who resides in the White House or which party controls Congress, it is only natural for investors to be concerned about the future outlook for jobs, taxes, market regulation and other economic issues.

We can’t (and won’t even try to) predict the outcome of the election – there are many factors at play that will influence voter sentiment one way or the other between now and November. In politics and economics, trends that may seem steady and predictable are always subject to abrupt and decisive change. For example, the S&P 500 rose 52% in the first two-and-a-half years of Bill Clinton’s presidency, but his term in office is also remembered for the dot-com bust. Similarly, when George W. Bush was re-elected in 2004, the U.S. was in the midst of one of the longest economic expansions since World War II, yet his second term was marred by the Great Financial Crisis.

Below are some factors that we believe will continue to influence the economy regardless of who is sworn in as our next President – and thus should be part of your financial planning and decision-making process.

The Stimulus Bill Will Come Due

At some point our government will have to find ways to pay for the many programs enacted to ease the financial pain of the pandemic. As of this writing, the U.S. Congress has appropriated nearly $2.4 trillion for Coronavirus stimulus packages, and trillions more may be added to that amount. Whoever is in office during the next four years will need to take a hard look at alternatives for raising tax revenue to help cover the ballooning deficit.

Estate Tax Exemptions May Change

A possible solution to the revenue shortfall may be to reduce the estate tax exemption, currently at $11.58 million per individual. While we don’t know if this (or any tax increase plan) will become a reality, investors would be well-advised to update their estate plans, ensure that they have established vehicles to transfer wealth to their heirs, and perhaps gift some assets sooner than later.  We are, of course, available to discuss these matters with you.

Near-Zero Interest Rates Will Persist

As long as Covid-19 remains a threat to our lives and livelihoods, we are likely to see a continuation of the current Federal Reserve policies, including extreme liquidity and near-zero (or, in inflation-adjusted terms, negative) interest rates. In this environment, investors are not able to derive any sort of meaningful yield on ultra-safe fixed income instruments. That fact has driven many investors, ranging from individuals to major institutions such as pension funds, insurance companies and endowments, to channel their investments into stocks, levitating the equity market to valuations that seem disconnected from economic reality.

Stock Prices Will Reflect the “TINA” Market

In the absence of acceptable yields, investors’ dollars have flooded into stocks due to the so-called “TINA” (There Is No Alternative) effect. However, the run-up in stock prices, and the likelihood that we have not seen the last of the Covid-19 economic strife, suggests that investors should exercise caution.

At MV Financial, we remain committed to protecting our clients’ portfolios on the downside. In most cases, this means maintaining defensive positions in assets that offer liquidity and quality, while keeping our allocation to equities in most portfolios at the bottom end of each portfolio’s target range. When we do invest in equities on behalf of clients, we often pursue a dollar-cost averaging strategy, making incremental purchases of specific assets over time in an effort to smooth the impact of volatility on the overall purchase and ultimately buy in at a better average price.

Recognizing that the nation’s economic path over the next four years is largely unknowable, we advise investors to focus on what they do know: the importance of setting concrete investment plans – and making decisions based on your specific goals, time horizon and risk tolerance.

As always, please feel free to reach out to us at any time to discuss your investment and financial questions. We wish you and your family well.  While there are still uncertain and perhaps even difficult times ahead, we remain optimistic about the longer term, and regardless of the economic outlook, we are here for you whenever you need us.

Stock prices didn’t exactly surge this week, even as the S&P 500 finally set a new record high on Tuesday and thus, for the moment anyway, formally ended the shortest bear market in the history of the world. On that record-setting day there were actually more stock prices in decline than advancing. But, as is so often the case, it was the Fabulous Five of Amazon, Apple, Microsoft, Alphabet and Facebook, with their combined heft of about 25 percent of the index’s entire market value, that pushed the ball over the goal line. And so began yet another round of debates among the chattering class of the financial marketplace about just how overvalued stocks are.

Overvalued relative to what, exactly? That is what we will be looking at this week.

The P/E and its Mirror Image

Often, when we say a stock is overvalued we mean that its price is high relative to some fundamental measure of the company’s financial performance, like price-to-earnings (P/E) or price-to-sales (P/S). And by these traditional measures stocks are very expensive. The P/S ratio of the S&P 500 today is 2.44 times, almost exactly where it was in March 2000 at the peak of the technology bubble. Put another way, only once before in history has the overall market been as expensive as it is today.

But there are other ways of looking at value. If you turn the P/E ratio upside down you get another metric: the earnings yield, representing a company’s net profits divided by its share price. You can then compare this to the yield on some other type of security – say, for example, Treasury bonds. In the chart below we show this very comparison: the earnings yield of the S&P 500 less the yield on the 10-year Treasury.

Many Moving Parts

So what is that chart telling us, and is there an argument in there that perhaps stocks are not as expensive as they might otherwise seem? Well, yes and no. Let’s break it down a bit further.

What seems fairly clear from that chart is that the relative yield on stocks versus bonds at the present time is not particularly out of line with longer-term norms. The earnings yield on the S&P 500 is around 3.64 percent, while the 10-year Treasury currently (as of yesterday) was fetching a yield of 0.64 percent. Subtract one from the other and you get 3 percent, which in turn is just above the 5-year average of 2.8 percent. Relative to bonds, in other words, stocks are neither unduly expensive nor particularly cheap.

That’s a fine argument as far as it goes – but in some ways it is also not an apples-to-apples comparison. The yield on an ultra-safe bond like a Treasury security is basically a very low-risk stream of income, all of which the investor receives simply by holding the bond. The earnings yield of an equity security is another thing entirely. Holding a share of common stock gives the investor a theoretical claim on the earnings associated with that share. But it is the company’s discretion what to do with those earnings: reinvest them into the company or pay out a portion in the form of dividends. As a shareholder, in other words, your claim on those earnings is much more tenuous than that of a bondholder’s interest payments (which, in turn, is why you would naturally expect stocks to return more than bonds to compensate for that additional risk).

There is also something of a circular argument going on if one uses relative yields to make the case that equities are not overvalued. Think about the earnings yield formula: earnings divided by price. In the past six months the denominator of this equation – the price of the S&P 500 – has gone up more than 50 percent. At the same time the numerator — earnings — has fallen for two consecutive quarters. Both of these trends have the effect of depressing the earnings yield. But it is a bit of a stretch to argue that stocks are not expensive specifically because rising stock prices have made the earnings yield lower!

Who’s Right?

As usual, there is no hard and fast right or wrong answer here. No one single valuation measure – not price-to-sales, not the earnings yield, not some other thing – supplies a definitive answer to the question of how to position one’s portfolio. Every investor has a specific set of financial objectives built around three considerations: growth, protection of capital, and income. Looking at different measures of value – and, importantly, breaking them down into their component parts – helps to supply different pieces of the puzzle. For example, a historically high price-to-sales ratio might suggest that protection of capital is a near-term concern, and perhaps it is time to carefully rotate out of some of the more stretched parts of the market into areas of better relative value. On the other hand, consideration of the relative yields between stocks and bonds would inform an income-seeking investor that safe bonds are a bad place to be right now and stocks look relatively attractive (this, by the way, is the widely understood although never explicitly stated objective of central banks in their monetary stimulus programs).

Often this kind of analysis turns up more questions than answers. And that’s our job every day – to ask the hard questions, challenge our thinking and look below the surface to ensure we are leaving no stone unturned to help us make the right decisions for our clients and the money they have entrusted to us.

Very few things are certain in times of economic downturn. One thing you can hang your hat on, though, is that market pundits will scour the contours of every letter of the English alphabet looking for the perfect visual symbol to align with their views on what the downturn-plus-recovery will look like. It seems that you cannot properly characterize an economic cycle without the prop of “[letter of choice]-shaped recovery” to underscore your thesis.

The Alphabet Song

Hope springs eternal for those who embrace the letter V, in which the good times come roaring back with all due speed. There tends to be an abundance of these folks in whatever presidential administration happens to exist at the time of the downturn, and they dominate online financial chat rooms.  The letter U, on the other hand, suggests a more gradual, tempered period of adjustment before things get back to normal. This is a good look for furrowed-brow habitués of the “Meet the Press” or “Face the Nation” green room. Then there is W, for those whose memories stretch back to the “double dip” recession of 1980-81. Last – but by no means least in number — are the gloomy Cassandras holding aloft the letter L, implying that it’s not even worthwhile to look for signs of a recovery as far as the eye can see.

The recession of 2020 has introduced a new letter to the usual mix. This recovery has produced the baffling contradiction of a soaring equity market alongside the worst headline economic numbers since the Great Depression. But there is a letter for that! Squint hard at the two price lines below and see if you can identify a childish scrawl of the letter K. We have helped illustrate by providing point-to-point directional trends (in crimson).

We’ve covered this ground before: the recovery in the stock market has been uneven and highly in favor of the technology giants that dominate the Nasdaq Composite (shown in green). But there is a larger story here than just relative stock market trends, a story that gives substance to the notion of a “K-shaped recovery.” Think about small cap stocks. In the second quarter of this year the aggregate earnings of companies that make up small cap indexes like the S&P 600 (blue trend line above) and the Russell 2000 were negative. Small businesses on whole lost money. By comparison the combined earnings for the S&P 500 for the same period are in the range of $234 billion, even after suffering the disruptions of the pandemic. The outperformance of indexes heavily weighted by mega-cap tech companies is easier to understand in the context of a K-shaped recovery: the large have gotten larger and more successful, while the fortunes of the small have turned the other way.

The Case for Caution

This divergence of fortune is true out in the real world as well. The recession is already over for many of the more fortunate among us, whose jobs proved to be portable from office to home with minimal interruption and whose assets – notably stocks and real estate – are percolating along nicely. For a great many others, the recession is not only not over, it is getting measurably worse. Economic benefits from the CARES Act have expired, rents are overdue and the small businesses where they work are still shuttered. These people – at least 16 million of whom are still entirely out of work – are not the beneficiaries of surging prices for expensive leisure toys like boats and private planes (which businesses are very much on the upward trajectory of that K-shape).

Ultimately, though, luxury goods are a relatively small niche area of the economy. An overall, broad-based return to growth depends on more than high-end sales to the few who can afford them. And that recovery is threatened. It is threatened by the inaction in Congress which appears set to spill into the August recess and then the intransigence of what will assuredly be the bitterest of election seasons. It is threatened by the inability of millions of small and mid-sized businesses to regain their footing, rehire their employees and return to profitability. It is threatened by the persistence of the virus in the face of an abject failure of will, discipline and action at the level of a national strategy to deal with it.

All of which, in our opinion, calls for continued caution and resisting the siren song of FOMO. Stocks have had a good run, especially the large cap beneficiaries of the “big get bigger” trend. But in the end the upward-sloping arm of the K-shaped recovery needs its downward-sloping mirror image to morph into another shape. There are many structural headwinds in the way of that happening any time soon. We may see continued upside in this resilient rally, but there enough risks at play to maintain our commitment to protection on the downside.

New month, same old stuff. The virus is still on a coast-to-coast rampage, the economy is still stumbling through the fog and Congress is still deadlocked over how to help. And asset markets of all stripes are still in full-on rally mode. Are things looking great? They must be, since everything from blue-chip US mega-caps to small caps and emerging markets are going gangbusters. Are things looking pretty terrible? They must be, since yields on 10-year Treasuries are back down to where they were at the height of the March panic, while inflation-protected TIPS yields are below minus (yes, minus) one percent. Are we in for a resurgence of inflation? We must be, because gold surged over $2,000 per ounce for the first time ever this week.

So who’s right? Or is there some rational reason for everything to be rallying at the same time?

Risk On, Risk Off

Here’s a snapshot of a world where assets that usually signal a flight to safety happily coexist with those typically favored by risk-seekers.

While the driving force of the rally in equities has come from the large cap growth stocks we talked about in last week’s column, making this the shortest bear market in S&P 500 history (top left chart), other equity asset classes have surged as well, including small caps and emerging markets (top right chart). Normally when these “risk on” asset classes do well it suggests an optimistic view of the world filled with expectations of dynamic growth in sales, earnings and economic output.

That view is out of step with what the bottom two charts seem to be telling us. Government securities tend to do well when investors see pain and trouble down the road. Yields on US Treasuries have fallen significantly in the past several weeks as our abject failure to contain the coronavirus became clear and sent the much-ballyhooed “reopening” back into reverse. TIPS, which are inflation-protected Treasuries (lower left chart) are now trading at record low yields of minus 1.08 percent. Gold (lower right chart) is another “risk off” asset, traditionally seen as a hedge against inflation. The shiny commodity also surged into record territory this week, trading over $2,000 per ounce.

TINA’s World

While the “everything rally” seems strange on its face, there is a driving force that explains at least part of it. That driving force is negative interest rates. A sizable chunk of securities in global fixed income markets trade at negative nominative yields. That expands further still when you take into account negative real (inflation-adjusted) rates as we saw with the TIPS example in the chart above. For a certain type of institutional investor – think pension funds, insurance companies and endowments with fixed spending plans – it simply is not workable to park the majority of your investable portfolios into ultra-safe bonds with negative purchasing power at best, negative income at worst.

These investors are not equity bulls – they are not piling into the stock market because they buy into all the silly babble about the “rocket ship economy” of certain political leaders’ fantasies. They are in the stock market because of TINA – There Is No Alternative. If a pension fund decides it has to increase its equity allocation, say from 35 to 40 percent, the result is a lot of new money coming into the market – much more than the collective volume of those over-caffeinated day trader bros with visions of V-shaped sugarplums dancing in their heads.

This is the world the Fed created. While the immediate benefits to quantitative easing and all those credit liquidity facilities are clear – forestalling a complete meltdown of financial markets – the longer-term risks are equally clear. As long as inflation stays low the Fed can keep pumping money into the system. If the gold bugs buying up precious metals are right about inflation, though, then this has the potential to be a collapsing house of cards. If there is one market view that you really, really want to be wrong, it is the high-inflation view. For what it’s worth we do not see compelling evidence of inflation surging much beyond the Fed’s two percent target in the next several years. But it would be wise not to rule it out completely.

We learned many things about the world on Thursday. As usual, some were edifying and others were beyond cringeworthy. One the one hand, we found out that the total output of the US economy, as measured by Gross Domestic Product (GDP), fell by an annualized rate of 32.9 percent from the previous quarter, by far the largest quarterly drop since recordkeeping began in 1947. On the other hand, the collective quarterly sales of four prominent enterprises – Amazon, Google, Apple and Facebook – rose by $32.6 billion from their levels one year ago a double-digit increase. Take that, coronavirus!

The GDP numbers came out at 8:30 am, before the markets opened. The companies reported their earnings after the 4:00 pm market close. In between those bookends the S&P 500 dithered along in negative but not too negative territory, as if to say “sure, the economy’s in a pretty crummy place, but technology, amirite?” Indeed, the stellar performance of technology stocks throughout the pandemic has helped make the relationship between the market and the economy different, entirely different, from that of the other two recessionary periods of this century.

The chart below shows the stock price performance of the S&P 500 against real GDP growth since 2000. Contrary to the 2001 recession and the more painful one of 2008, this time there has been no sustained drawdown in stock prices. Things went from fear to FOMO in no time at all.

The Tech-onomy

Amazon, Google, Apple and Facebook are expected to produce about $900 billion in total revenue for calendar year 2020 (based on already-reported results and analysts’ forecasts for the remaining two quarters. Adding Microsoft – the other member of the Big Five that had already reported before yesterday – puts that total well over $1 trillion. That’s no small amount of money. But neither the revenue contribution of these firms, nor their profitability, nor other operational metrics like employee headcount or productivity make them notably different from market leaders of earlier eras – think General Motors in the 1950s, or ExxonMobil (then just Exxon) in the 1970s or IBM in the early 1980s – in the context of their size and contribution to the overall economy.

Where today’s Big Five stand out is their stock market capitalization, defined as the stock price per share multiplied by the number of shares outstanding. Their total market cap runs to $6.3 trillion (based on 7/30 closing prices). That’s just under 23 percent of the market cap of the entire S&P 500. It’s also 32 percent of the total US GDP of $19.4 trillion following that sharp second quarter collapse.

What all of this means is that while today’s technology leaders are not demonstrably more important to the overall economy than the leaders of bygone dominant industries were in their day, they are valued much more highly by the stock market. When you hear someone say “the stock market and the economy are not the same thing,” here is Exhibit A. Now, this clearly is not the only reason why the current stock price performance in that above chart looks so different from that of previous recessions – and tech outperformance was a pre-existing condition before Covid-19. But it is a meaningful contributing factor.

A Bridge to Nowhere?

There was another bit of news yesterday that was overshadowed by the combination of economic releases and clownish performative politics intended to distract (we will just leave that one there). Or, rather, non-news, since it would have been news if legislators on Capitol Hill had managed to reach some form of agreement on a new relief package before the expiration of benefits from March’s CARES Act, which expiration happens today. But there is no agreement in sight, with the White House and Senate Republicans talking past each other, let alone engaging constructively with Democrats.

One f the basic go-to explanations for optimistic sentiment in the stock market has been the imagery of a bridge. Congress and the Fed set the foundations back in March – with the CARES Act and the Fed’s multifaceted liquidity facilities – with enough raw materials (money and other benefits) to extend through the middle of the summer. By then we should either have arrested the spread of the pandemic or, if necessary, had enough time to come up with a way to extend the bridge further out. Neither of those things happened. Today we are standing at the edge of that unfinished bridge and the other side is still a very long way away.

Perhaps nobody has been more articulate, more emphatic, and indeed more empathetic about the importance of extending household and business relief than Fed Chair Jerome Powell. In his press conference after this Wednesday’s FOMC meeting Powell once again spelled out the plain facts: this is a health crisis the time line of which is driven entirely by the virus, not by economic wishful thinking. To avoid having temporary economic reversals become more permanent, fiscal policymakers need to do their part. If that doesn’t happen then the “fiscal bridge” erected in March becomes a bridge to nowhere. That has dark implications for the resilience of this market rally, with potential consequences neither supercharged tech stocks nor the Fed itself may be able to blithely swat away. It wouldn’t take much for FOMO to revert to fear.

Something unusual has been happening in recent weeks. Equity markets outside the US, those long-suffering European and Asian bourses trailing in the flamboyant wake of the seemingly indestructible S&P 500, have woken up and gotten their game on. In the chart below you can see on the left-hand panel that the MSCI EU index (the crimson trend line), comprising equities in the European Union, has resoundingly outperformed our domestic blue-chip index over the past three months. So, to a lesser extent, has the MSCI EAFE index (in green) which includes developed Asia-Pacific markets along with Europe.

An FX Tailwind

What’s behind this surprising spurt of outperformance? The right-hand side of the panel explains the lion’s share of the answer. In the past three months the euro – the currency in which most EU equities are denominated – has risen by 7.4 percent against the US dollar. Think of it this way: if you are a US investor and you own assets denominated in euros, the value of your assets goes up (in US dollar terms) when the foreign currency appreciates. You add the currency gain to whatever amount your asset grew in its own home-currency terms, and voila – enhanced total return.

Dollar weakness versus the euro, in other words, is the dominant variable explaining the performance of EU stocks versus their US counterparts. Now, this in itself is not particularly newsworthy – currencies go up and down against each other all the time. But something happened in the EU this week that has the potential to give a more structural (as opposed to merely cyclical) boost to the European currency and to European assets more generally.

The M&M Effect

The EU is famous for being unable to reach common agreement for important region-wide initiatives. Historically a not insignificant part of the difficulty has been the intransigence of Germany, the EU’s largest economy, in lending fiscal support to the region’s weaker and more indebted members. But several weeks ago German Chancellor Angela Merkel and French President Emmanuel Macron came together in support of an aggressive €750 billion relief program (about $870 billion) to help EU nations provide relief to their citizens and businesses as the coronavirus pandemic continues to weigh on the economy. Merkel and Macron (who would be called “M&M” more often if they actually cooperated more often) spearheaded a long and often contentious series of negotiations to bring the rest of the EU on board. They finally achieved success at 5:31 am this past Tuesday morning, Brussels time.

Now, €750 billion may not sound like much in a world where central banks routinely speak of printing trillions of dollars for economic support. What makes the EU program noteworthy – what justifies the “potential game-changer” language in our headline – is how the program will be funded. The EU will issue regional sovereign bonds, likely to come with a triple-A rating by the credit rating agencies. This exceeds by a magnitude of 13 times or so the amount of EU sovereign debt currently in existence (a small amount of issuance mainly used to fund loans to Ireland and Portugal during the Eurozone crisis a decade ago). It represents a new safe haven asset class that will likely find its way into many asset allocation decisions, the most important of which is likely to be central bank foreign exchange reserves.

A Paler Shade of Green

The overwhelming majority of foreign exchange reserves held by national central banks are, unsurprisingly, denominated in US dollars. The greenback has been the world’s reserve currency since the end of the Second World War. But the world today looks nothing like the world of the Bretton Woods framework that oversaw the first quarter-century of the postwar period. China, which barely had an economy to speak of at the time, is now the second largest economy in the world. It is also the largest single foreign holder of US dollar assets, mostly Treasury securities. And, in a very much related development, it is engaged in an increasingly hostile contest for global influence with the US.

Now, nobody rationally expects that China is going to start dumping Treasury bonds wholesale – that would be an impulsive and self-defeating move contrary to the long game played by Xi Jinping and his Beijing mandarins. But the ability to diversify its reserve mix to a greater supply of euro-denominated paper will probably be of great interest to Chinese central bankers. It could be an important thread in a gradual weakening of the dollar’s singular preeminence in world markets.

None of this will happen overnight, if at all. Tectonic shifts are usually not the result of one single event but rather of thousands of independent, seemingly unrelated tensions that build up and eventually bring the plates into collision. It’s worth one’s time to pay close attention to trends in euro-denominated assets in the coming weeks and months. They may be suggestive of more structural changes to follow.