What is Driving the Market?
How can it be? The more the economy degrades and the worse the health crisis gets, the more the stock market goes up! A bottom-line comparison of a June 2020 versus a March 2020 brokerage statement almost washes away that nagging sense of confusion (the elixir of bigger numbers behind dollar signs). The mixed emotions for most of us stem from our exasperation of trying to square how we think the market should work, with what is playing out before us. As stewards of capital, BSW does not always agree with the current market playbook. BSW has learned it is better to understand than agree.
So, what is driving the market back to where all this started in late February? All the potential answers seem to have one thing in common – a massive amount of money is competing for a place to live and grow (even just a little).
I have always pictured in my mind those simple plinko boards (made famous on the Price is Right game show). A ball gets dropped at the top and bounces and tumbles its way through the pegs to the bottom, where it lands with a clunk in one of several buckets. At its heart, the financial system can be seen as a version of this. As money is created, it is dropped into the top of a giant plinko board sorting mechanism. As the Fed lowers rates and infuses cash, the buckets that represent safe income fill up first and balls are diverted to the next safest asset. As these receptacles fill up, balls start to drop into progressively riskier buckets in search of return.
Since stocks are considered the riskiest of liquid assets, it is this bucket that is now seeing most balls drop its way. Even if this flow slows, which it has lately, stocks can still go higher.
Due to the massive amount of uncertainty driven by the COVID pandemic, most companies have withdrawn forward-looking earnings guidance. With fundamentals therefore a guessing game, and treasury bonds yielding less than nothing (on a real basis), it opens the market up to one of its historically most potent catalysts – sentiment and momentum.
Think about it this way: Absent an anchor in the form of true fundamentals for stocks, the market can drift higher on the back of even just a few of those balls dropping into the stock bucket – that is if all the other holders of stocks are still onboard with holding their positions. With 10-year U.S. treasuries yielding 0.65%, (the other major liquid alternative to stocks), why sell now if all arrows point to more stimulus and continued lower rates? The potential for further gains in equities seems to beat the surety of low to no returns – at least for now.
From the U.S. to Europe to China, all major global economic players have signaled that they will do anything to rescue the economy. Along these lines, do we really think the U.S. will completely shut off the $600 unemployment supplement at the end of this month? During an election year? Milton Friedman used to say, “nothing is so permanent as a temporary government program.”
The following government programs, intended to be temporary upon creation, are now deeply etched into the bedrock of the U.S. system: SIPC, Federal Home Loan Bank, Fannie Mae & Freddie Mac, Federal Crop Insurance Corp, and Tennessee Valley. The longer the COVID crisis lasts, the more likely it could become that the $600 payments become a form of universal basic income (UBI) – something that many countries have experimented with and which Alaska has been doing since 1982.
Inflation is the Enemy of Bonds
The Fed is already supporting the market by buying almost every flavor of bond in the open market. It’s not a stretch to imagine them buying the iShares S&P 500 ETF along with the bond funds it has been hoovering up, especially if the market starts to roll over.
Back to our example of relative value between stocks and bonds. It seems that if bond yields stay tame, the market can continue its drunken stumble higher. By essentially controlling the yield curve through bond purchases, the Fed has helped assure that this will be the case.
The biggest risk to this dynamic seems to be inflation. Inflation is the enemy of bonds, since the income from a bond needs to be viewed in real (inflation adjusted) dollars. Should inflation meaningfully pick up, bond investors might sell in earnest and force yields higher. Higher yields might entice stock investors to ring the register and move money to bonds as they become relatively more attractive.
Inflation, while very tame for years, is starting to bubble under the surface. With so much money chasing fewer goods around the world, it seems like just a matter of time before it shows up in the data.
A new world order is also ostensibly pushing us closer to inflation. Just four months ago, there was no bread on the shelves of many U.S. grocery stores. This type of experience makes paying up for a loaf of bread seem rational, given that going without was a recent reality. The food at home portion of CPI recently clocked in at +5.6% annualized inflation.
Globalization has also swung into reverse. China and the U.S. are again at loggerheads. Cost savings from outsourcing may disappear as industries shift back to U.S. soil. In May, the U.S. put out a 16-page memo, outlining the new, strategic approach to dealing with China. In summary, it states that the decades-long practice of constructive engagement with China is over. U.S. hopes of China becoming more open and fairer have been replaced with a U.S. commitment to win the power struggle. Following the memo, China flexed its muscles in Hong Kong and is attempting to punish the U.S. for its ties with Taiwan by threatening sanctions. I’d like to think cooler heads will prevail, but most heads I see these days are steaming more than my patio after a hot summer’s day rain.
Per usual, there are opposing forces that are tugging the market in different directions. We have highlighted that for now, the Fed seems to be overwhelming the negative forces that are front and center in our daily lives and causing masks to be the new fashion statement.
The winners in this environment have been the stocks that have proven they can grow through thick and thin. Here, technology has taken a front-row seat. You need only look at the top five stocks in the S&P 500 to realize that the companies attempting to usher society into a cleaner, more efficient, more empowering future are taking over. Microsoft, Apple, Amazon, Facebook, and Alphabet (Google) now make up over 20% of the entire S&P 500. This is the highest concentration of top five stocks in a generation.
Impact/ESG Themed Investing
One good that has come of this crisis is that it has shined a light on the world’s troubles and awoken a generation to inequality (both racial and financial), healthcare issues and, by extension, environmental issues.
Larry Fink, CEO of the world’s largest asset manager, Blackrock, held a virtual conference recently where he stated that environmental impacts on the economy, if we don’t do something to course-correct now, will be like having a COVID pandemic every 10 years. Climate change is no longer our grandchildren’s problem, it’s our problem. Every industry will be disrupted.
To that end, BSW continues to advance our Impact/ESG (Environmental, Social and Governance) themed investing platform across all asset classes. ESG, or “full information investing” as it is sometimes referred, is no longer a trend, but the fastest growing part of the investment world. It is estimated that 1 in 4 dollars in U.S. professionally managed assets are in ESG strategies.
Statistics dating back to the 1970s support the fact that ESG investing need not sacrifice returns. Over the long run, ESG strategies seek to avoid the embedded risks that are getting bigger every day that we kick them down the road. As we attempt to avoid these risks and lean into the companies that are trying to solve the above-mentioned issues, we feel that no matter what direction the market, COVID, politics, or inflation takes, the path to long-term success may have already been paved. If you would like to join us on this path, please feel free to reach out to learn more about Impact/ESG investing and how BSW, as a B Corp and Public Benefit Corp, is Making Life Better for all stakeholders.
Until next time…Let the balls drop where they will, wear your masks and be well.
Director of Public Investments