Q2 2020 Market Update: Follow the Money

Finance and Money concept, Money coin stack growing graph with sunlight

These are troubling and confounding times. In a recent poll, the vast majority of Americans said the country is going in the wrong direction. Amid a global pandemic, the Trump administration bungled its response, shirked any responsibility, declared victory, and dumped the hot potato in the laps of state and local governments. Public health measures have become controversial, and threats of violence have even caused the resignation of dozens of public health officials around the country. Wearing a mask has become a political—not public health—matter. Opponents say a mandate to wear a mask is an infringement of personal freedom—even tyrannical. Tyrannical? Really?

The recent surge in stock prices is also confounding to many. The economy is the weakest in more than 80 years, and corporate profits have plunged. Yet the NASDAQ 100 index (of largely technology stocks) is at a record high.

The stock market, however, isn’t the economy. In fact, the economy is usually a contrary indicator for future stock market returns. A strong economy is usually accompanied by widespread optimism and an inflated, overvalued stock market. A weak economy and widespread pessimism go with a depressed, undervalued stock market. (Remember, high starting valuations lead to below-average future returns, and vice versa.)

Now, however, in an extremely weak economy, the stock market is extremely high (and overvalued), which should lead to below-average future returns. Yes, there is recurring optimism about a COVID-19 vaccine and an economic recovery, but there is another crucial factor that is supporting stock prices.

“Follow the money.” Aside from being the key clue in the political thriller “All the President’s Men” and the name of a website we use to assess corporate political involvement, followthemoney.org, it also is a clue to the stock market’s action in the second quarter, which was the best in 20 years. Lots of money is now flowing into financial markets, and money flows can overwhelm fundamentals (at least over the short term).

The money is coming primarily from two sources. First, the U.S. Federal Reserve is “printing” an unprecedented amount of money and injecting it into the financial system, and a substantial portion of that money has likely spilled over into the stock market. Second, hedge funds have bought huge amounts of stock. Hedge funds often use a “momentum” strategy of buying what has been rising rapidly in price. When a trend changes, or markets are volatile, their abrupt strategy reversals can amplify market moves. Early this year, with stock prices near record highs, hedge funds were heavily positioned for continued gains. When prices plunged in February, they sold heavily, exacerbating a record decline. As the market surged in April and May, hedge funds bought heavily (and covered their “short” positions), further extending recent gains.

Hedge funds are not alone. Stock index funds have become extremely popular in recent years, as they are an inexpensive way to participate in the long-term growth in the stock market. When the stock market is rising, investors like to buy, which drives prices even higher. The reverse is true in a declining market. When the market trend changed and began to move higher in April, investors large and small piled in, as they feared missing out on the next market rise.

What is a sensible, long-term investor to do? Step back and take a breath. In the meantime, until better widespread opportunities arise, hold more cash than usual (despite money market yields of close to 0%), prune stocks that have become heavily overvalued, and selectively buy lagging, undervalued stocks (primarily international).

The bond market and the (short-term) money market are also baffling. Interest rates are at record lows, so in general, we plan to wait for better opportunities (higher yields). Until then, our focus is on short-term maturities to limit portfolio volatility. It might be a little while at least before rates rise. Investors seem to be complacent about rates not rising indefinitely, especially after Fed Chairman Powell recently said that he expects money market yields to be close to 0% through 2022. We see two problems with that. One, what does that say about the health of the financial system and the economy? Would rates need to be near 0% if prospects were strong? Two, the Fed has an abysmal forecasting record for the level of interest rates, even for the rate that it sets (the Federal Funds rate).

In summary, we favor cash, low stock allocations (and stocks with high dividend yields), and short-term bonds. For even more protection against a large decline in the stock market—which we expect—clients without them might consider put options.