Island Light Quarterly Commentary (Oct 2020)
“The surprise is that you continue to be surprised.” ― Jill A. Davis
When life takes an unexpected turn, how do we behave? Even as we try to drown out the noise, angst, misery and illness that is supposed to be our current lot in life, then God, or man, surprises. The rains fall in the desert, hand sanitizer returns to the grocery shelves, the miracle of new birth overwhelms you, Arabs and Israelis come to an agreement. Good news may come in surprising packages, but that goodness was there all along.
Bad news also surprises, as we have learned to our pain this year, with the death of a loved one, the loss of a pet, an unexpected failure, job loss or separation, even a global pandemic We feel losses more strongly than we celebrate gains, what the behaviorists call loss aversion bias. This leads us to become fatalistic, overwhelmed by a sense of loss of control of events and we often can make bad choices when we are overwhelmed.
But isn’t this what life is about? Good and bad news? And isn’t that OK? We shouldn’t stress about what we can’t control, nor give in to the things that we can control. We don’t know what happens next despite all our rigorous planning and best educated guesses. Sometimes what happens is good, sometimes not, and whether good or bad, life goes on. What a boring world if we didn’t have adversity to overcome or good news to celebrate.
When it comes to investing and finances, we measure the probabilities of outcomes, knowing that surprises will occur. Our appropriate response is to plan for ups and downs by diversifying our wealth and insuring against known risks of loss. In hindsight, knowing things that occurred, we can be disappointed that we ‘should have seen it coming’ or ‘been more aggressive’ or whatever, but we live in the present. If we try to invest on yesterday’s news we often come up a day late and a dollar short.
So we turn to the financial markets, where surprises abound. For all the bad news in headlines from around the USA and the world, we are awash in liquidity, looking beyond the current misery of the global pandemic and forecasting future growth – at least that is the current state of the US large cap public equity market.
Global equities rebounded 8.1% in the third quarter (MSCI ACWI IMI) and are slightly up 1.4% for the year. US equities returned 8.9% for the quarter and 5.6% for the year to date, led by large returns from the largest tech stocks. Overseas equities markets were positive in the quarter (up 6.3%) but remain underwater for the year, off – 5.4% through September 30 (MSCI ACWIx US), with emerging markets outperforming developed markets. US Volatility as measured by the CBOE’s S&P 500 Volatility Index (“VIX”) ended the quarter at 26.4, settling into the 20-30 point range for the last few months, down from 53.5 on March 31 and up from 13.8 on December 31. Any value above 20 is considered to be higher than normal.
One observation about US stock market index levels today is the concentration of excess returns in a few household names. This concentration contributed to the disparity of returns between large and small, growth and value, and in different market sectors. The top 5 companies by market cap in the US (Apple, Amazon, Microsoft, Google, Facebook – growth stocks all) represented just under 20% of the market cap at the beginning of the year and more than 25% at the end of the quarter. The average year-to-date return of the companies was more than 35% through September 30 while the (weighted) average of the rest of the S&P 500 was -1.4%. Partly as a result of this concentration, growth stocks are up 20.6% YTD and value stocks are down 11.5%. While not entirely surprising, given the change in consumer and business behavior since the beginning of the pandemic, the return differential is striking and may indicate that this market rally is not all that it cracks up to be.
US Bonds, as measured by the Bloomberg Barclays US Aggregate Bond Index were again positive for the quarter, returning 0.6% and 6.8% for the year to date. Inflation protected bonds did very well in the third quarter (up 3.0% Bloomberg Barclays US Treasury TIPS) and longer duration treasuries were flat in the quarter but up strongly for the year. Year to date, the best performance is from long dated US Treasuries, up 19.8% YTD (IA/SBBI Long Govt Index), the worst from High Yield Bonds at (-8.4%) (ICE CCC rated). Interest rates, as measured by the benchmark 10-year Treasury yield, ended the quarter at 0.69%, trading in a narrow range between 0.60 and 0.70% for the past six months, but very much lower since the beginning of 2020 (1.92%). These rates continue to be at their lowest range of the past 60 years.
The combination of low interest rates, monetary expansion and fiscal stimulus have contributed to an increase in consumer confidence to 101.8 in September from 86.3 in August. And business confidence has improved as well. According to McKinsey, more than half of all executives surveyed say economic conditions in their own countries will be better six months from now, while another 30 percent say they will worsen. And except for those in developing markets, 3 respondents in every region are more likely to predict that conditions will improve than that conditions will worsen.
This increased confidence combined with super low mortgage rates contributed to significant growth in the US housing sectors over the summer. In the month of July, housing sales soared 23% from June, hitting an annual pace of close to 1.5 million. Sales of new single-family homes jumped 14% month-over-month in July, hitting an annual pace of 901,000. For the first time ever, the median price of an American home is greater than $300,000. The strength we’re seeing in the housing market today is roughly equal to what we saw in 2005, when the housing market peaked. Downstream effects of the housing boom have been evident in consumer spending on furniture, appliances, and home improvement, which has outperformed spending across most other sectors. Construction employment has also recovered briskly (Zacks).
Despite this selective optimism, there remains the extraordinary problem of Covid 19 and its terrible consequences on many vulnerable citizens. The virus continues to spread globally (the so-called second wave, although its not clear that we ever left the first one) and while a US national shutdown is unlikely, regional shutdowns seem certain to occur. Forecasts from Coresight indicate that 25,000 US companies could close permanently in 2020, an enormous loss. We also expect that discretionary spending on travel for business and pleasure will remain weak and lead to stresses in vacation lodging, air travel, in-restaurant dining, sporting events, retail stores and the like. As we indicated earlier in the year, we also expect demand will remain weak for commercial office space and energy-related goods and services as stay-at-home behaviors remain. The longer the virus continues, the more likely that these temporary changes in consumer behavior will become permanent.
Looking forward, we continue to worry about the impact of the global pandemic on growth. The virus doesn’t seem to be slowing down. We expect that the economic growth numbers will be good, albeit coming off the dismal drop in demand from the first and second quarters and that some equity sectors will continue to shine. Whatever the outcome of the US Presidential elections, volatility should decline when the uncertainty associated with the election is over. Just knowing who is the next President and who controls the legislature will help calm markets. Overseas valuations still look to be relatively attractive, as they have for some time. In the same way, value stocks appear to be inexpensive relative to growth stocks. However, that does not mean that it is time to rotate into value and overseas stocks. There are few clear signals to invest aggressively at this time.
We have been well served for the last few years by remaining diversified, rebalancing to target allocations infrequently, buying selective growth positions and staying short duration and long credit in our fixed income allocations. The surprisingly resilient US economy remains our most potent ally in our long-term allocation strategies and we hope to weather the new surprises that are sure to appear with this approach. Peace and prosperity to you all.