September Investment Comments
Uncertainty makes people uncomfortable, and there is plenty of uncertainty to go around. The virus continues to stubbornly stick around; we don’t know how widely it will spread if schools and colleges are opened to in-person learning; we don’t know if one or more vaccines will be effective; and then there is an election this fall in case you haven’t heard.
It is said, “The market runs from uncertainty.” Yet the S&P 500 and NASDAQ indexes just reached all-time records. The Dow Jones Industrials Average is about 5% below its all-time high while the Russell 2000 index of small stocks is 8% below its high. Stock indexes at all-time highs don’t sound like a market running from uncertainty!
Of course, we are in “unprecedented” times, but there still must be an explanation. Actually, there are two. One is simple. The government is gunning the engine. Since late February, the Federal Reserve has taken on $2.8 trillion in assets, swelling its balance sheet 67%. About 79% of the money has gone to buy U.S. government securities. The Federal Reserve has bought about 80% of the government debt issued over the past six months. It does this by crediting the seller’s Fed account, thereby “creating” money. The other 21% of the increase in the Fed’s balance sheet went to mortgage securities (15%) and corporate loans and securities (6%). The purchase of these assets “creates” money too. Some of this money stays in bank accounts, but some of it seeks higher returns, thereby boosting stock and bond prices.
The other explanation for the stock market’s rise is more conventional. After a disastrous March-May period, the economy is simply doing better in recent months. GDP fell at an astonishing annualized rate of 33% in the second quarter. Europe fell 40% and Japan was down 28%, although Japan’s economy has been struggling for longer following a sales tax hike last fall.
Since the second quarter GDP report, all we have are fragments of data to string together. Retail sales in July were an all-time high, representing the third straight month of gains. In fact, on an annualized basis July sales were 1.7% higher than in February when the pandemic was just unfolding.
The rebound goes well beyond shopping. The Institute for Supply Management (ISM) puts together indexes that measure manufacturing and service industries from multiple angles. Its manufacturing index improved to 52.6 in June and 54.2 in July after three months spent struggling below 50, the line that separates growth from decline. Other data on manufacturing support this rebound. ISM’s Services index rose to 57.1 in June and 58.1 in July after being below 50 for two months. The favorable results are fairly widespread.
Unemployment remains very high, but tends to be a lagging indicator rather than a measure of where the economy is headed. The unemployment rate in July was 10.2%, almost triple the record low last reached in January, but well off the revised high of 13.3% in May. It probably isn’t surprising that about half the jobs lost are in restaurants and bars. Employment in other sectors of the economy remains down, but is coming back faster than hospitality.
While it sounds like the economy is moving in the right direction, more of that dreaded uncertainty is heading our way. The federal government’s $600 weekly supplemental unemployment benefit expired at the end of July. While President Trump has issued an executive order to continue that benefit at $300 per week, it remains to be seen whether that will pass legal or Constitutional muster. Meanwhile, the Democrat-controlled House, Republican-controlled Senate and the Administration appear far apart on additional aid. The market doesn’t seem concerned that the economy may lose its crutches, and we don’t know if it is ready to stand on its own yet.
The economy faces other headwinds as well. Many K-12 schools plan to operate virtually, and the impact on the availability of parents for work is a big unknown. Also, layoff limitations under certain business loan programs expire on October 1st.
Investors have been confident, some would say overconfident, in recent months as economic indicators have improved and as the government has indicated a willingness to shower money on the economy, seemingly putting a floor under stock prices. However, good values in the stock market have become harder to find. Small stocks and financial services companies seem to be one of the few pockets of value. Most companies will see lower sales and profits this year, and share prices of the few exhibiting continued growth are frequently stratospheric. Many of them are leading technology companies, particularly in software and online services. As always, selection of individual companies remains of utmost importance.
Scott D. Horsburgh, CFA