How We Work
November 29, 2021
For those of us who have “desk jobs,” COVID-19 changed the way we work, and we probably will never go back to how and where work was done in 2019. The implications are significant for almost every aspect of our economy. As a nation, we have become more productive, and report that our lives feel more balanced.
More than 18 months after the initial shutdown from COVID-19 in March of last year, only a fraction of white-collar employees have returned to the office in many major cities. Kastle Systems International is the major provider of card swipe systems for office access that have become ubiquitous in most cities. They collect data from 2,600 buildings in over 130 cities around the country. They show that New York City card swipes are down 52% from pre-pandemic levels. In San Francisco, swipes are down 57%. Chicago figures are comparable. New York subway ridership is below 50% of pre pandemic levels, and that is after recovering from levels that were far lower. Kastle Systems’ weekly index of U.S. metro areas currently shows that employees are still going to the office only an average of two days per week. As one would expect, southern states with more liberal reopening policies show a higher in-office presence, but still substantially lower than two years ago. It is fair to say that a significant portion of the workforce has settled into some type of hybrid work routine.
A hybrid environment lets individuals have the best of both worlds – no commute and none of the commensurate costs and hassles. It still allows collaboration through messaging and video apps, and in-person collaboration on in-office days. As many jobs have evolved into an interface between an individual and a terminal or computer, being “together” has become less of a priority.
The implications for both cities and less densely populated areas are significant. Large coastal cities and other major population centers may see a material plateau or decline in values for both commercial and residential real estate. The tax base will decline for sales, real estate, and income taxes. This will be a major funding issue for these areas. Service sector jobs that supported the urban commuter will disappear. Demand for support services in suburban or rural areas will increase, as new services will be needed for those working from home. The $1.9 trillion American Rescue Plan passed earlier this year funneled massive grants to municipalities, but this was a one-time funding. Cities that experience permanent population declines will experience declines in quality-of-life issues.
Many employee surveys have shown that most employees want to continue to work under a hybrid office/remote schedule. We all were forced into it last year, adapted to it, and don’t want to completely give it up. The reason many want a blend is that they see the benefits of both. We shouldn’t push too hard against this change; the experiment will allow us as a group to find the proper equilibrium. It has encouraged a more rapid rate of job change as well; resignations are at record levels, as individuals reassess their priorities and think about how they want to work. Economically, it has been for the better. GDP is at record highs, even with a smaller aggregate workforce. A satisfying and rewarding work life helps us all to live happier and more rewarding lives.
Random thought: “The only way to do great work is to love what you do. If you haven’t found it yet, keep looking. Don’t settle.” -Steve Jobs
“Look for the job that you would take if you didn’t need a job” -Warren Buffet
Repressed, Not Impressed
September 28, 2021
Why are bond yields so low when inflation is increasing? Why is the cost of food, housing, automobiles, and rent all going up faster than incomes? Welcome to the world of financial repression. The U.S. government is a net debtor. They have borrowed, spent, and now they owe. Inflation reduces future purchasing power. This is bad if you own assets, unless their value increases even faster than the rate of inflation. The total U.S. debt is now over 130% of GDP, while it was under 100% less than ten years ago.
Annual Federal spending from 1953 through 2019 was between 16% and 22% of GDP per year. Generally, it ran below 20% if the economy was growing, and increased to slightly over 20% during recessions. It rose to 24% in 2009 before dropping back down, but spiked to 31% of GDP in 2020, the highest level since the Second World War. Debt and spending typically grows along with the economy, and that generally causes no fiscal issues or stress.
As the debt load has increased, the burden has been lessened by generally low interest rates. Interest expense for the Federal government as a percent of annual GDP was less than 2% until the 1981 recession and interest rate spike. It was between 2% and 3% annually from 1981 through 2000, and then moved back down below 2% per year as interest rates fell and Treasury debt matured and was reissued at lower interest rates.
With current debt levels at record high percentages of GDP, and enormous future spending commitments as the boomer generation retires, higher interest rates would endanger the fiscal position of the U.S. government. The Treasury (Janet Yellen) and the Fed (Jerome Powell) would like to keep interest rates below the level of inflation. While this is not a good deal for bond investors, it certainly helps the Treasury repay the debt as tax collections increase due to inflation but the cost of borrowing stays low. Financial repression is the ability of governments to borrow and pay interest at a rate below inflation. Repression helps them as the seller of Treasuries but hurts investors as the buyer of Treasuries.
So, Powell and Yellen like the current status quo; low bond yields and high asset prices. High asset prices and low borrowing costs keep the economy humming. If we could run with this kind of status quo for a while, maybe the debt to GDP ratio would start to come down.
Unfortunately, Congress wants to get in the game with an enormous spending bill. Both Republicans and Democrats are responsible for the current dire state of fiscal affairs. The Democrats increase spending and claim they favor fiscal responsibility through higher taxes, and the Republicans cut taxes and claim they favor fiscal responsibility through decreased spending. Both parties usually only get half of what they want, and deficit spending grows.
There are some economic and market positives. The employment picture is strong, and wages probably have to go up across many industries. Consumer confidence may continue to support the economy and the recovery from the impact of COVID-19. One big positive is that the employment situation looks positive across the spectrum. Professionals that sit in front of a monitor have seen increased flexibility with work from home and are hesitant to give it up. Many are demanding and getting greater flexibility from their new employers when they change jobs, in addition to increased pay. Skilled industrial production workers are in short supply and will be able to gain pay increases as well. Direct service workers, usually among the lowest on the pay scale, will gain greater pay as it is necessary to get them to return to the workforce.
As the COVID-19 Delta wave recedes, there should be another surge of consumer spending, travel, and confidence. This will serve to support earnings and the market. Our shorter duration fixed income strategies will provide some level of protection against higher rates, especially at the long end of the curve where the Fed has less of an impact. Municipal bonds have also been strong performers in fixed income, with positive returns year to date versus negative returns in most other fixed income sectors. For most economic and fiscal issues, economic growth is the salve that makes things better.
Random thought: “I have not failed. I’ve just found 10,000 ways that won’t work.” -Thomas Edison
Good vs. Bad
August 4, 2021
So many of the decisions we make in life are tradeoffs, both the big decisions and the little decisions. We evaluate the pros and cons of where to live, where to work, what career to choose, etc. As investment professionals, we do the same thing when making an investment decision. Often, we are evaluating many variables on both the good side and the bad side. We also have to assign a certain weight to each variable; what is more important to investment success, and what is less important? We also have to evaluate the certainty of our judgement on each factor. If we expect a likely outcome, how certain are we? If we are wrong, is the downside risk large or small? It’s complicated.
There are significant crosscurrents of good and bad affecting the markets and the economy right now. Most immediately concerning is the Delta variant, resulting in rising cases across many countries. Viruses often mutate, typically becoming more infectious but less deadly, as appears to be the case with Delta. From an economic point of view, our behavioral reaction to the Delta variant is as important as the medical consequences. Even a semi-voluntary, significant reduction in mobility and economic activity can have wide ranging consequences. If people choose to travel less, stay home more, and spend less out of fear, there will be economic consequences.
So far, the surprising strength of the economic recovery is outweighing the fear and uncertainty generated by the Delta variant. Air travel has recovered to 80% of pre-pandemic levels, restaurant visits have fully recovered, and gasoline consumption has recovered to more than 95% of pre-pandemic levels. Consumer confidence going forward is still a concern; the percentage of individuals in a recent Gallup survey that believe the COVID-19 situation is getting better has dropped significantly. As we saw in 2020, when confidence in our political, health, and journalistic institutions is at odds, the societal fabric frays.
The economic and market news has continued to be better than expected. Both revenue and earnings have continued to surprise on the upside each of the last four quarters, with the magnitude of the surprise increasing. This probably explains the positive return of the S&P 500 through earnings season in the month of July, after a 15% gain in the first six months of the year.
Why worry? The level of debt and borrowing is exploding, and it is being monetized through purchases by the Federal Reserve. The Treasury issues debt and the Fed purchases a significant portion of it. They also are the major buyer of debt in the home mortgage market. This is effectively “printing money” and distributing it through various government programs. Few have stopped to think that the $20 bill in their wallet is actually an IOU. It is non-interest bearing government debt. We work for two weeks and receive a paycheck; that chit can be exchanged for something of value we want to consume in the future, be it seven days or seven years from now. Governments throughout world history have succumbed to the seduction of printing money. It has ended badly for all of them.
The generally shorter effective maturity debt we utilize in many of our fixed income strategies reduces risk and exposure to changes in expected inflation and interest rates. This is the best investment approach we found to mitigate risk in fixed income investing. High-quality bond investments have proven to be the best way to mitigate equity investment risk.
Even if a ‘return to normal’ move continues after the Delta variant subsides, we now know we are not going back to the normal we had before the COVID-19 pandemic. Life and work in 2022 will be different from life and work in 2019. Many have used this period to evaluate their work/life balance, seemingly to the benefit of both the companies and their employees. Real GDP is now higher than it was pre-COVID-19 with five million fewer individuals employed. Higher GDP is the good, and we have made a positive step in overall economic productivity through this period. Fewer employed is the bad, and we need to continue to work to find a place for all who can contribute.
Random thought:“I have dreamt of this moment since I was a kid, and honestly nothing could prepare you for the view of Earth from space” –Richard Branson, Virgin Galactic Founder
Let’s Get Real
June 28, 2021
Inflation has been the topic du jour during the last few months. For the past year, the Consumer Price Index is up 5%. Over the last 30 years, it has only been higher for a short period in 2008. Should we be concerned as investors and consumers? Persistent inflation can harm economies, and if it is not controlled, it can bring down economies and governments. We believe both inflation and deflation can be very harmful and cannot always be controlled by what many believe to be an omnipotent Federal Reserve.
Inflation is corrosive. It lowers the value of our work, our savings, and casts uncertainty on long-term financial agreements. It can reduce economic risk taking, which is essential for growth. If you are a lender or a borrower, what should you assume for the value of the dollars that will be repaid at a later date? Will the interest rate on the loan compensate for the risk of losing principal, and any unforeseen inflation, that reduces the return on the dollars that were loaned? Many equate price increases directly with inflation, although that is not always the case. Prices can change significantly in short periods of time in order to allocate scarce resources, such as when demand spikes before an economic supply chain can fully restart. This is part of the “noisy” inflation numbers we are getting now. Jerome Powell and the Fed believe the current jump in inflation is related to supply chain and reopening constraints, and will prove to be transitory. We believe it is prudent to accept this explanation until it is disproved.
Many economic indicators are adjusted for inflation to get at a “real” number, that is, the change in value or level that is not caused by inflation (or deflation). Economic growth is usually measured by a change in GDP; this is announced quarterly and is a real, or inflation-adjusted, figure. Growth over the last few decades has trended in the 2% per year range, with higher or lower figures in recoveries or rescessions. While Real GDP contracted in 2020 due to COVID-19 as parts of the economy were shut down, it is expected to grow as much as 7% or more this year. Real growth is fundamental because it is the core source of real asset growth and improvements in quality of life over time. It is also the source of real wage growth, which had been rather stagnant for decades before it began to rise in the years before COVID-19. If inflation were to stay at an elevated level, this virtuous cycle would run in reverse; investors would demand higher returns for risk, fewer new investments would be funded, risk taking and innovation would decrease, and consumer purchasing power and real wage growth would decline.
The Fed would like to keep interest rates low to keep the economy humming for an extended period of time. They do this by both taking action and through their communication about when they may take action. After their last meeting, they made policy by communicating their thoughts about the timing of changes in rates and bond purchases, both of which influence the economy. Effective market direction through communication allows them to limit actual changes in rates and bond purchases, and we believe this is their preference now. Low real interest rates, which is the rate paid after accounting for inflation, helps debtors repay the debt and decreases the cost of borrowing. Coming out of a downturn, this is good for individuals, corporations, and the government, which has borrowed heavily over the last year.
As we have said before, the economy is actually more productive now overall than it was before COVID-19. Economic output per worker is higher now than it was prior to COVID-19. Nevertheless, the economy has to continue to expand to bring unemployed and discouraged workers back into the economic fold. Keeping the economy humming is the way to do that, and, ultimately, continued investment, optimism, and economic growth should bring the benefits of real growth after inflation to more members of society.
Random thought: “All growth…is the result of risk-taking” -Jude Wanniski
May 27, 2021
The first quarter earnings reports continued to provide upside surprises as the economy expands and the COVID-19-based restrictions are eased. The average earnings surprise for the S&P 500 has been near 20% for the last four quarters, and the average upside surprise to sales for all S&P 500 companies in the first quarter was 4%, the highest upside sales surprise of the recovery. Every sector of the index delivered positive sales and earnings surprises. These strong results have allowed the index to gain almost 6% so far in the second quarter, equaling the 6% gain in the first quarter.
As we have discussed before, the areas of the economy that were more productive were less affected by COVID-19 than the sectors of the economy that are less productive, namely the leisure and hospitality sectors. As a result, the economy has recovered to nearly the same level of GDP output that it had prior to the decline, but has done so with a level of employment that is only 95% of pre-COVID-19 employment. This higher level of productivity is good for investors, good for those who remain employed, and good for the economy as a whole. Higher wealth stems from increased levels of productivity. Higher wages also stem from increased productivity, although a higher level of skills will be required of the employee in exchange for the higher wage. A higher wage mandated by the government will result in lower levels of employment if prospective employees do not possess the required skillset to offer in exchange for the higher wage.
Different sectors of the market have been going through stealth corrections and consolidations in 2021, even as the S&P 500 moves towards new highs. The largest drawdown peak to trough for the S&P 500 this year is about 4%, and it has happened twice. Looking at several indexes that represent other areas of the market, the Russell 2000 Small Capitalization Index fell almost 10% in just seven trading days in March. The NASDAQ Composite Index fell over 10% in three weeks during the first quarter, and dropped 8% in the two weeks ended May 12th. The Philadelphia Semiconductor Index fell over 14% during a three-week period in the first quarter, and fell over 13% in the five-week period ended May 12th. These rolling corrections in different sectors of the market can go largely unnoticed, and they are a healthy way to limit the frothiness in some sectors while allowing the overall market to remain in an uptrend. One reason the S&P 500 has not had a correction of 5% so far this year is that the index contains companies that have benefitted during the period of COVID-19’s heaviest economic impact, but can also benefit as the economy moves back towards normalcy. Even with large tech companies making up a significant portion of the index, the S&P 500 has proven its resiliency.
We have seen over the last five weeks that Bitcoin and other crypto-currencies are not a one-way trade. While Bitcoin is still positive for the year, it had a 24% decline during mid-January, and was down almost 50% from its mid-April high through last weekend. Some may find it ironic that the pseudo-currency marked a high on April 15th, the day tax payments are usually due in the U.S. The jury is still out on whether Bitcoin can deliver on any of its promises as a secure, valid currency broadly accepted in exchange for other goods, a store of value, and an inflation hedge. Due to the extreme volatility and drawdowns, it does not appear a reliable store of value. This volatility causes it to also get a failing mark so far as an inflation hedge. Have Bitcoin price movements been at all correlated with longer term changes in inflation? No. It has also been hailed for its benefits of privacy and anonymity. These features also have their downsides, as funds are very difficult to track and are the accepted method of payment for some forms of criminal activity and corporate blackmail. Those crypto backers that utilize the new exchanges for trading and investment are sacrificing most of the privacy and security benefits in exchange for convenience. Will the original benefits win out in the long run? We have a long way to go and there will be many twists and turns along the way, including environmental concerns over the carbon intensity of mining and processing Bitcoin.
Random thought: “For greater privacy, it’s best to use bitcoin addresses only once.” -Satoshi Nakamoto, presumed alias used by the founder of Bitcoin
Does the Fed Have Our Back
March 24, 2021
The Fed has a dual mandate: pursue full employment while keeping inflation low. As the years have passed, they seem to have added even more to their plate. They have shown concern for instability in both domestic and overseas markets, a weakening or strengthening dollar, the fiscal deficit and debt, climate change, and income inequality. Some say they have one arrow and multiple targets. Actually, they have created more arrows for themselves by becoming a key purchaser of both Treasuries and mortgage-backed securities. Once again, the markets are leaning on the Fed for continued support and fearing when that support might begin to be curtailed.
The last rate increase cycle that took place in 2017-18 is instructive. From December, 2016 through December, 2018, the Fed implemented eight quarter-point increases, moving the Fed funds rate from 0.375% to 2.375%. At that time, we did not believe there was any compelling reason for the Fed to start a tightening cycle; CPI vacillated between 1.5% and 3% even as unemployment continued to drop below 4%. The S&P 500 gained over 20% in 2017, but fell 5% in 2018, with a 15% correction in the fourth quarter of 2018. We always believed that the markets would have to force the Fed to stop the increases, and the first cut came in July of 2019 as inflation and GDP drifted lower and the stock market was close to flat for nine months prior to the cut. At no point in the last decade did consumer inflation move over 2.5% per year on a sustained basis, even as unemployment moved below 4%.
In addition to what was learned in that rate cycle, the Fed now has the added uncertainty of the pending COVID-19 recovery. Will businesses be willing to rehire anywhere near as quickly as they laid off employees? The Federal debt has ballooned, and the Fed certainly worries about the ability to finance that debt at low rates. They also know that those on the lower end of the income scale suffered disproportionately from the economic effects of COVID-19. They know that easy money doesn’t significantly help that portion of the population until the unemployment rate again moves towards past lows. Those with non-specialized skillsets are the first to be laid off and the last to be rehired. The Fed has already told us that they will allow inflation to run above 2% for a period of time. Will they let it run at 3% or more if they believe that there is still work to do on the employment recovery? That certainly is more likely now than it was a few years ago.
Recent economic numbers have come in below expectations due to winter storm Uri. Almost ten million people lost power, the greatest number since the New England storm of 2003. This resulted in a downtick in home sales and first quarter GDP, which is now expected to be in the 6% range rather than 8%. Don’t be fooled; the economy continues to move toward a broader reopening as the U.S. vaccinates millions of people per day, and the caseload for the virus continues to drop even as people increase their activity, travel, and interactions. We will see a move up in the CPI, potentially above a 4% annualized rate, in the coming months. Supply chain bottlenecks will exist as the economy rebuilds inventory. Some of those supply line constraints already exist in the semiconductor space, and the shortages have been so severe as to lead to temporary shutdowns in major automotive plants. We would expect inflation to settle back after the spike over the next few months.
The uptrend in the stock market should continue broadly in line with the reopening and increased vaccinations. The market leaders of the past year have corrected, with the NASDAQ Composite Index down over 10% through March 8th. Value stocks have outperformed growth stocks this year in anticipation of the economic reopening.
Longer term interest rates have also risen over the last two months, resulting in negative returns in most longer fixed income portfolios. This move off last year’s lows was also expected, but impossible to time. It is also another sign of the forthcoming economic recovery and can be managed through proper portfolio positioning and allocation. With higher portfolio yields currently available, portfolios should be less price sensitive to similar rate moves going forward.
The Fed does have investors’ backs this time. They want to see the economy heal, and they want to do all they can to help those who were hurt most by COVID-19. Expect them to continue to resist a push for tightening, regardless of the inflation numbers, until the unemployment rate has moved below 4% for a significant period of time.
Random thought: “Our greatest responsibility is to be good ancestors.” – Jonas Salk, inventor of the polio vaccine
Auld Lang Syne
December 29, 2020
The traditional New Year’s Eve song has its origins in Scotland in the late 18th century. It was a song of longing and melancholy for better times past. That can certainly describe the feeling we have all had for most of this year. In the investment world, this time of year usually involves a summary or reflection on the past year as well as a look forward to what the next year may bring. Let’s skip the former.
We look to 2021 with excitement and anticipation. The prospects for a broader return to a more normal economic and social environment are strong. COVID-19 vaccine distribution has begun, but success will not arrive on a given date, it will come over time. The more individuals that gain immunity by experiencing a bout with the virus or by getting vaccinated, the more difficult it will be for the virus to continue its spread. There will be a balance, and precautions will still be needed for a period of time. Expect continued disagreement over the level of precaution that will be necessary, as has been the case throughout the pandemic this year. Nevertheless, risk in any given situation will begin to decrease.
We find many reasons to be optimistic about economic and market prospects for 2021. Housing has been a beneficiary of changes in behavior and outlook during the pandemic. New and existing home sales have skyrocketed, and backlogs at many builders remain high. This building boom is supported by a surge in existing home prices and sales, and by a move in borrowing rates to historic lows. Both new and existing home sales rates are up over 20% since 2019, and prices are up more than 10% this year. An uptrend in home prices supports consumer optimism and future spending.
At the corporate level, inventories have been drawn down to lower levels, and capital expenditures have been cut at many companies to preserve cash through these uncertain times. Both have room to grow to much higher levels in 2021. Both will need to be triggered by an increase in consumer expenditures, but that too could be on the horizon as vaccines are more widely distributed. Weakness in the dollar could add a tailwind to the earnings of multinational companies going forward.
The Federal Reserve has pledged to stay out of the way during the recovery. Fear of the Fed “removing the punch bowl” has tempered rallies in the past. Currently, the Fed is telegraphing rates near zero for at least the next two years, and possibly longer. They also have claimed that they are willing to tolerate a rate of inflation above 2% for an undetermined period of time. This could allow companies to raise prices while still taking advantage of low borrowing costs, resulting in more positive leverage to margins and earnings.
The household savings rate has ballooned during 2020 and could be another source of funds for spending and growth in 2021. Total household savings has increased by approximately $2.5 trillion dollars through the first ten months of 2020. This increase has taken place even as consumers have paid down debt this year. This level of savings has been a net detractor from GDP in 2020 and could be a significant add to GDP in 2021 and beyond.
Regardless of the positives, equities and fixed income markets have moved up significantly in 2020. If we look back to the market correction in 2018, we may find some indication of a potential signal of a market top. One place to look is to those areas of the market that have had the largest moves up over the past year. The S&P 500 peaked on January 26, 2018 and did not show a 10% gain over that level for more than 20 months. Bitcoin peaked on December 17, 2017 and fell 40% over the next five weeks as the S&P 500 continued to rise. The most volatile areas of the market may provide early clues for the next correction.
We thank you for the trust you have placed in us, and please share our best wishes for a happy, safe, and prosperous 2021.
Random thought: Success is a lousy teacher. It seduces smart people into thinking they can’t lose. – Bill Gates
The Election is Over!?
November 24, 2020
We felt that using inclusive punctuation in the title was the best way to give a nod to our readers across the political spectrum. We are glad it is over, if just to end some of the uncertainty. Everyone can now take a deep breath and look past November 3rd. The election found a number of ways to surprise political followers. Trump becomes a one-term president in a closer outcome than many expected. Joe Biden has shorter coattails than expected, as Republicans outperformed in both Senate and House races. Both chambers will be narrowly divided, and Democrats will control the House by as little as three to five seats. One Iowa Congressional District has not yet been called. In that election, the current difference is 47 votes out of almost 400,000 cast. For those who want any new legislation to be a product of compromise, this is a good thing.
As election tension plagued the first week of November, the markets moved higher. In what is now being called “Pfizer Monday,” Pfizer announced positive results from a vaccine test prior to the market open on November 9th, and the stock market jumped 3% on the open. All of this takes place as Covid-19 continues to spread and hospitalizations have increased. We are not out of the woods, but the market is broadening as companies that would benefit from a more open economy and a more mobile populace continue to rebound in the markets. We have been identifying these companies and adding them to our strategies for weeks. Performance may be difficult to interpret as this transition takes place because next year’s leaders may not bear much resemblance to the market leaders of this year. As measured by the Russell indices, value stocks have been outperforming growth stocks since the end of July. In the first seven months of the year, growth outperformed value by over 25%.
Even as confirmed cases of Covid-19 continue to increase, measures of economic activity and demand are increasing as well. We seem to continue to find ways to live with the virus even as we continue to take precautions. Indicators of manufacturing activity are rebounding above pre-virus levels, inventory levels of homes for sale are at multi-year lows, and prices and sales of homes are at multi-year highs. Automobile sales have rebounded completely back to their early 2020 levels. Inventories of other goods are also low. It appears the consumer is signaling an end to the crisis before businesses. Many industries have cut back on capital spending due to the virus, and there is room for a rebound as we move into 2021.
Fixed income portfolios have participated in the rebound since March. Total returns in virtually all categories of the markets are positive for the year, and many portfolios have returns in the mid-single digits year to date. A continued reopening of the economy will help support credit and borrowing in the fixed income sector and will also continue to bring demand from investors. Navigating the markets this year has been perilous, but investors are beginning to be rewarded for their patience and persistence.
Happy Thanksgiving to all from Dana Investment Advisors.
Random thought: “Americans have always understood that, truly, one must give in order to receive. This should be a day of giving as well as a day of thanks.” – Ronald Reagan
October 27, 2020
Fall is one of the best times to be in Wisconsin. The kaleidoscope of changing maple, oak, and elm leaves, Packer football, and deer hunting season are just some of the things that give a natural rhythm to our lives here. These seasonal highlights serve as a respite from the evolving fears of a persistent virus, a highly polarized political season, and investment markets that seem to defy logic. Weekend sports seem to be one of the few breaks from the toxic news cycle, whether it is watching youth soccer, or professional sports. Like many, we are ready for this election to be over.
Economic activity continues to be in a recovery despite the persistence of the coronavirus. Retail sales have settled back to a normal range after two months of severe contraction and two months of strong recovery. Automobile sales are back above a 16 million annualized rate after falling below a nine million annualized sales rate in April. Housing has been on a tear. After averaging 700,000 new homes sold per month in 2019, the sales rate approached one million in August. The annualized sales rate of existing homes is now almost 20% above the 2019 rate. The equities of companies in these areas have responded as well, with the S&P Home Builders Index up 28% this year. Retail sales have followed a similar V shape, and over half of the twenty-five members of the S&P Retail Index are up for the year. Even the S&P Consumer Services Index, which contains some of the businesses hardest hit by the pandemic, is above its level on March 1st. The consumer services index is comprised of restaurants, hotels, and cruise lines.
If the markets are forward looking, they are still optimistic. The S&P 500 Index is only 7% below its early September high. Maybe the markets believe Trump will win and maintain his pro-growth policies. Maybe the markets believe Biden will win and pass a large stimulus package that will bridge the economic gap created by the pandemic. About 25% of S&P 500 Index companies have announced third-quarter earnings, and the results have exceeded expectations at a greater rate than the last few quarters. The Russell 2000 Index of small capitalized stocks has outperformed the S&P 500 Index since June 30. This is the formula for a strong market. Price earnings ratios (P/E) always spike when coming out of a trough, and that was true this summer. The good news is that the market P/E has not increased over the last four months, as expectations for forward-earnings growth has been as great as market price increases.
In the fixed income markets, yields on longer Treasuries have been creeping up and are now near seven-month highs. As long as this happens in an orderly fashion, we view it as a good sign that market participants are returning to risk taking and feel that growth will continue. Our bond portfolios are underweight Treasuries. Another sign of positive risk taking is that yields on corporate securities have not gone up any faster than Treasury yields, indicating a continued confidence in corporate debt.
We understand this Viewpoint is shorter than in the past, but we will have more to say in a few weeks when we have election results and third-quarter earnings.
We wish the best for everyone, and please exercise your duty and your right to vote.
Random thought: “We do not have government by the majority. We have government by the majority of who participate.” – Thomas Jefferson
Growth vs. Value
September 29, 2020
Growth or value? This question has been a facet of investing for decades, but has come into even more pointed focus in the last few months. Growth stocks have continued a decade-long trend and massively outperformed value stocks for much of 2020, but in recent weeks, performance has been more even. The change suggests many of the factors that propelled growth forward since the pandemic have been fully absorbed by the market. But is that enough to stage a changing of the guard for value investing?
We believe two main factors benefited growth stocks coming out of the pandemic-induced economic slowdown. First, the areas of the economy that the pandemic hurt most tended to be lower-wage, lower-productivity industries that provide person-to-person service. Examples include retail, transportation, airlines, hotel, and restaurant industries. By and large, these are value stock categories. Energy stocks, which are another large component of value indices, were also punished as the economic slowdown dampened demand.
Companies in higher-productivity areas, such as technology, were less affected by the pandemic. These businesses primarily fall into the growth category. Expectations of an extended low inflation environment have also supported growth stocks. Growth stocks’ valuation is based largely on the stream of earnings they will earn in the future. Low inflation means the value of those future earnings streams are worth more because they won’t be inflated away.
These metrics had helped push growth stock valuations higher in recent months. At some point, markets were bound to reassess extreme valuations. That has happened recently with the tech-heavy NASDAQ falling 10% into correction territory just three days after setting an all-time high at the beginning of September.
Meanwhile, low inflation is a headwind for a value company. These companies generally have more leverage than growth companies. If there’s low inflation, a dollar in the future maintains its value. Lower inflation increases the debt burden of leveraged companies in real dollar terms. Low inflation also makes it more difficult for these companies to raise prices or increase revenue to aid in servicing their debt.
The recent slump by growth stocks has put growth and value performance roughly in line with each other since the end of July. Many wonder if extreme valuation differences between growth and value stocks mean value is now due for its own run of outperformance. For this to happen, we think the market will need more signs of economic improvement.
Value stocks are typically more economically sensitive than growth stocks, but that is even more true in the recent downturn. To a large extent, value stocks are associated with companies that primarily benefit when people are moving around and spending money. That just doesn’t happen when people are nervous about coming out of their homes and engaging in direct social contact with other individuals.
However, news about the virus has started to sound more encouraging. Although the number of new daily confirmed cases remains high, the infection rate is trending down as the number of confirmed cases divided by the number of tests is falling in many areas. Offices are starting to reopen. For example, JPMorgan recently announced it will call its traders back to their New York offices. Once we see more states reopen and the economy begin to rebound, we wouldn’t be surprised to see value outperform growth.
At Dana, our strategies are core equity strategies. We look for investments that have characteristics of both growth and value stocks. We are valuation-conscious, but we don’t make directional calls in our portfolio with an intentional shift toward value or growth. However, some of our strategies have started to take advantage of attractive valuations and invest in companies in the hotel, travel, and restaurant industries that would benefit as the economy gradually reopens.
We are also finding opportunity in stocks that have a good “self-help” story. The one silver lining in the recent downturn is that it has forced management teams to re-evaluate costs and think hard about how they can run their business more efficiently. Many have cut their capital expenditures or are looking for ways to deploy them more efficiently. We believe some of these businesses are poised to come out of the downturn running leaner than ever and could see a substantial earnings boost with even a modest economic lift. We will continue to perform our due diligence on these companies in the months ahead and deploy capital where we see opportunities develop.
Random thought: “Leave nothing for tomorrow which can be done today.” – Abraham Lincoln