“People can foresee the future only when it coincides with their own wishes, and the most grossly obvious facts can be ignored when they are unwelcome.”
George Orwell
Markets continued their rebound in the second quarter after hitting their pandemic panic bottoms on March 23rd. As already discussed in prior notes, major global governments and their central banks unleashed massive stimulus and liquidity to combat the economic costs of the pandemic. I say economic costs because shutting down the economy to combat Covid19 does have obvious economic costs and these are harder to quantify versus the healthcare costs that are highlighted daily by the media in terms of confirmed cases and mortality. As I said in my last letter, this is a health care crisis that cannot be solved with money in the short term but money can help alleviate the suffering for many that have been economically impacted through forced unemployment. This has bought us some time for the health care response by way of treatments and vaccine development which are now well under way.
For the last several years, I have said that when we hit the next crisis, the playbook from the Great Financial Crisis of 2008 and 2009 would get dusted off and that is exactly what has happened. Clearly a pandemic is a very different crisis than a financial crisis but the government response has been largely the same. Governments quickly lowered interest rates to essentially 0% and then created massive sums of money to buy assets in the open market thereby driving up asset prices and liquidity (i.e., Quantitative Easing). In addition to these central bank monetary actions, governments also implemented paycheck replacement programs with record speed. This is almost an electronic equivalent of what past Federal Reserve Chairman Ben Bernanke referred to as “helicopter money” when he said many years ago that deflation could be fought by just printing and dropping money from helicopters.
Make no mistake, these actions were necessary to prevent a massive amount of financial suffering. The US went from the lowest unemployment rate in over 40 years to the highest unemployment rate in 90 years all in just 2 months! This was a stunning collapse in employment and economic activity with the US economy falling almost 33% in the 2nd quarter. There were obviously some implementation hiccups and blatant fraud attempts with some of these programs, but by and large we should all be grateful for the help. Paying for these programs is not today’s concern but ultimately there will be some longer term consequences which will definitely impact the markets over the next 5 to 10 years. With this amount of debt in the system, it is hard to believe that interest rates will be able to go up much anytime soon. The US Federal Reserve has even said they foresee leaving rates essentially at 0% for the next 2 years and allowing inflation to trend over their 2% target for a period of time. We already have negative nominal rates on $15 Trillion of global bonds now and they are telling us to prepare for a prolonged period of negative real rates (return after inflation). Long term readers can appreciate that I have talked endlessly about inflation risks now for years and that was before the Covid19 monetary response.
All that said, the largest surprise to the majority of market participants (including myself) has been the obvious disconnect between the economic realities and the stock market recovery which has continued pretty unabated through July. I have been reconciling this divergence with simply one word: LIQUIDITY. All of this liquidity has been sloshing around and looking for a home for the next second, minute, hour or longer. A significant percentage of the working population were forced to stay home and given replacement funds (in some cases more than they were actually taking home after taxes). At the same time, there were no sports to bet on and no Vegas trips allowed (until recently). There is no doubt in my mind that some of this liquidity has found its way into hot momentum stocks by way of a new generation of pandemic day traders.
In the US, a brokerage firm called Robinhood has made trading stocks a little bit like playing Candy Crush with their deceivingly easy to use smartphone app. For example, investors are awarded a free share of some “trending” company at sign-up (usually a small cap company) where users scratch tickets to uncover what they received. They even have bursts of digital confetti when you make a trade! The average age of participants is 31 with half of participants having no prior investment experience. the first three months of 2020, Robinhood users traded nine times as many shares as E-Trade customers, and 40 times as many shares as Charles Schwab customers (as measured by average customer account balances). They also bought and sold 88 times as many risky options contracts as Schwab customers, relative to the average account size (read full article by searching “New York Times Robinhood”). The app highlights the top stocks traded by participants on the platform and offers a very easy interface all with free trading. Of course in the fine print, terms explain that in return for the “free” trading, Robinhood sells the order flow information to Wall Street so fast acting algorithms can profit from the order flow and ride the momentum. This arrangement is not unique to Robinhood but the amount that the app collects for this service is between 4 to 15 times more than Schwab for example. So while this platform is small relatively speaking, it is absolutely adding to the momentum strategies that are so prevalent these days.
All of this momentum has accrued to a handful of large technology names that have been perceived as dominating in a Covid19 world. The top 5 stocks (Apple, Amazon, Alphabet, Microsoft, Facebook), now represent over 20% of the S&P500 and the top 6 stocks are now almost half of the Nasdaq 100 index. At the same time, it is estimated that about 60% of all market trading volumes these days are by way of passive index strategies. So we have a handful of momentum names being day traded by first time investors driving the indexes higher while simultaneously many others have decided passive indexes make the best investment strategy! By the way, Canada is not immune to all of this with our star e-commerce player, Shopify dragging our index higher (it’s a great company but sports a nosebleed valuation). Shopify overtook Royal Bank some time back as the most valuable Canadian company and is now worth some $40 billion more at this point. We have seen this movie before with Nortel, RIM, Potash, Manulife, Valeant and more recently pot stocks and cryptocurrencies. Bubbles burst only after they have drawn in the most number of participants. But with historic market liquidity, the timing of such is very hard to predict. I actually heard a large money manager suggest that it was “okay to fly if you just sit close to the exit”!
Rest assured, we continue to think longer term and care about such quaint metrics like earnings and dividend yields. And I think we are currently in the “eye of the storm” where the sun is shining but we still have a good deal of bad weather to navigate to get through to the other side. We continue to hold above average cash balances looking for the second half of the “W”!
As always feel free to call anytime!