In Portfolio Commentary

Happy New Year and welcome to a new decade! Personally, I hope the stock market in the 2020s mirrors that of the last ‘20s decade -the Roaring 1920s. During that period the Dow chalked up average annual compound returns of 25%. Granted, it likely helped that it was coming off a very low level at the end of the prior decade. Back in 1921, you could walk into your local brokerage house, or “bucket shop,” and buy a share of a little company called Coca-Cola for under $20/share. At that valuation, Coke traded at less than 2x forward earnings; meaning it had a market capitalization of $10 million yet had earnings of over $5 million in 1922.

Coke peaked at $140/share in that 1920s bull market. If your great grandparents bought a single share of Coca-Cola in 1921 for $20/share and held it through all 11 stock splits, today it would be worth $250,400. That’s a lot of sugar water!

Of course, we all know what happened in October of 1929. Years of easy money, easy credit and borrowing to buy stocks (for the first time, regular citizens could buy stocks with as little as 10 cents down on the dollar) came back to bite investors. The whole system crumbled on itself during the Wall Street Crash and subsequent Great Depression.

Before you conclude that I’m about to make a dire prediction that investors are heading down the same path, read on. Although the current market looks like, walks like and quacks like the Roaring Twenties, we have reasons to believe this duck has different feathers.

Investors are entering this new decade on a liquidity-fueled high. Our global stock benchmark, the MSCI All Country World Index (ACWI), finished 2019 up 26.35%. Even bonds joined the party; the Bloomberg Barclays Municipal Bond 1 -10yr Index was up 5.63%.

Looking forward to 2020, we are optimistic that this current bull market, now in its 11th year, has more room to run. The U.S. consumer has proven resilient and some trade pressures are expected to ease in the coming months. With this background, BSW continues to favor emerging market (EM) stocks. After lagging in 2019, EM stocks seem cheaper and appear to offer higher growth opportunities, especially Asian growth companies. Small cap U.S. stocks have also lagged and now look like a better relative value next to their large cap brethren.

On the fixed income side of the equation, we don’t foresee yields moving much higher this year. The Fed has telegraphed that it is ‘on hold’ and that it would take either higher inflation or a significant increase in market risks to cause them to move rates in either direction.

On that note, BSW still believes bonds will be a critical, income-generating piece of client portfolios. They should offer valuable insurance in the form of protection from volatile stock markets. However, in anticipation of a lower-for-longer interest rate environment, the BSW Investment Group is looking into a custom-curated alternative means of producing lower-risk income in portfolios. As with any new investment ingredient, we are diabolically committed to thorough due diligence, so this might be a down the road offering. Stay tuned.

As you know by now, BSW is not focused simply on which investments offer the best return potential, but also (and arguably more importantly) where risk lies. We are always on the lookout for what could go wrong – we are a twitchy bunch over here, but that’s our job.

Right now, what is keeping us up at night (besides the 5 babies that BSW staff welcomed into the world in 2019) is the below chart showing how much money the Fed is pumping into the money markets through repurchase (‘repo’) agreements. Essentially, the Fed has injected hundreds of billions of dollars into the market recently to make sure that the market functions correctly and that short-term overnight lending rates stay in line with the Fed’s targeted funds rate, currently 1.50% – 1.75%.

The last two times the Fed pumped this much liquidity into the money markets was in 1999 in preparation for Y2K (a laughable event in hindsight) and again in 2008 in response to the financial crises.  Back in 1999, the added liquidity at a time when the markets were already cruising higher caused the stock market to go parabolic. As soon as the repo operations stopped, the market reacted by plummeting.

Below is the reaction of the current market to the latest repo announcement going into 2019 year-end. A 12% move higher in the S&P 500 with no other measurable catalysts is suspicious to us.

One of the main reasons the current repo operations are needed was described well by James Grant of Grant’s Interest Rate Observer. He observes that prior to 2008, historically, banks had ~10% of uncalled loans set aside in cash in case borrowers needed it in a crisis. That buffer always seemed to be enough. Today, with new regulations stemming from the great recession, that number is closer to 40%. This is cash that is required to sit idle in Federal Reserve deposits to create a safety cushion. It is cash that is not available to lend to stimulate the economy or to satisfy institutional investor demand for cash to settle trades.

In the chart below, prior to 2009 reserve balances with the Fed hardly registered as a blip.

In short, what we believe has happened is that the repo market as a percent of total Federal Debt outstanding has shrunk as primary dealers (think: JP Morgan and Citibank) have backed away due to their own liquidity issues. According to Jim Bianco of Bianco Research, the current repo market is 23% of Federal Debt outstanding – the same level that it was in 1979. It got as high as 84% in 2007. The Fed has had to step in and effectively take the place of primary dealers. It is now the pig that is keeping the plumbing of the market clear, allowing for the free flow of capital.

Provided that the Fed continues to inject liquidity into the market, funds will flow into liquid, high returning assets. The risks associated with this seem to be twofold. First, as stocks get bid up beyond their earnings potential, the subsequent downside becomes potentially larger. Secondly, how the Fed handles their new role of King of the Money Markets will be telling. They may indicate that these repo operations will remain in place indefinitely, or that they will be tapering off over time. Regardless, they’re now the largest single governor of the market – again.

Back in the days of flappers, derby hats, and Ford Model T cars, most of the financial excesses lived on personal balance sheets. This time it is primarily the financial system itself that is causing imbalances and profit-seeking market actors to lean too far. That alone gives us real hope. We believe it’s easier to push through shifts in monetary and fiscal policy than to change the financial behavior of an entire nation.

So, grab a Coke and enjoy watching the market (which is also on a sugar high) keep marching on. We’ll keep our enthusiasm in check and our risk radar on high alert.

Any guesses on what one share of a little company called Amazon ($1,891 today) will be worth in 2120?

Thanks for reading.

Craig Seidler

Director of Public Investments

 

 

 

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