“We have to practice defensive investing, since many of the outcomes are likely to go against us. It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favourable ones.”
— Howard Marks
The Great Divide: What is causing the disconnect between Main Street & Wall Street
Main Street and Wall Street have never seemed more disconnected than what we are seeing today. Ahead of last week’s pull back, the two largest U.S. markets posted double-digit returns on their way to reaching new all-time highs, yet double-digit unemployment rates told a vastly different story. Take a stroll around your local downtown and try to gauge the economic activity. How many stores are open? How many are bustling? How many restaurants will survive once the weather turns and patios are closed for the season?
According to the United Food & Commercial Workers Union, Canada’s restaurant industry employs roughly 7% of the Canadian workforce, as well as roughly 1 in 5 individuals under the age of 25.[i
As schools reopen and the potential for new infections rise, might we expect another series of more severe lockdowns that further dampen economic prospects?
In the face of this likely reality, why are stock markets shrugging off these concerns and continuing their march upward? In this issue of Innova Market Insight (IMI)s, we discuss the three key contributing factors:
- Free Money
- There Is No Alternative (TINA)
- Market Concentration
Howard Marks, the famed investor, uses an excellent metaphor to explain the current economic environment in his recent essay.
"To deal with particularly serious diseases, doctors sometimes have to take extreme action to save the patient: they induce a coma to permit the administration of harsh remedies, maintain life support, treat the disease, and bring the patient back to consciousness.
In the case of Covid-19, one of the worst pandemics of the last century, policymakers were similarly required to take desperate measures. Upon the eruption of the disease, epidemiologists told us it would spread exponentially, possibly killing millions.
In the absence of a vaccine, the only way to deal with the outbreak was to prevent those who had contracted the disease from spreading it to others. In order to do so, the authorities decided it was necessary to put the patient into a coma. Thus the economy was shut down to minimize interpersonal contact. Stores, restaurants, schools, places of worship, and entertainment and sports venues were ordered closed, travel was restricted, and people were told to work from home whenever possible. As we all know, the U.S. economy was largely frozen, causing 54 million Americans to file for unemployment benefits since March 21 and second-quarter GDP to shrink by an annualized 32.9%, three times the greatest quarterly decline in the 70 years of recorded quarterly history.
The comatose patient – the economy – required life-support, and the Fed and Treasury supplied it. They rushed in with trillions of dollars to keep the patient alive: payments to individuals and households; grants to distressed industries; general business loans and tax relief; loans to small businesses; aid to states, hospitals and veterans’ care; and guarantees for money market funds and commercial paper. These are sometimes described as stimulus programs, but that’s a misnomer: they were support payments designed to replace cash that normally would have circulated throughout the economy.
With the economy comatose and on life support, elected officials proceeded to administer the cure. In the absence of a vaccine, this was designed to take the form of testing to identify those who had the disease and tracing to identify those with whom they’d come into contact; quarantining and social distancing to keep them separate from others; and masking to prevent the asymptomatic sick from infecting the healthy.
When the number of new cases, hospitalizations and deaths declined, and in view of the desirability of allowing economic activity to resume, those in charge turned to resuscitating the patient. The economy began to reopen in May, supported by a near-zero base interest rate and the Fed’s provision of abundant liquidity, and the initial response was positive. Retail sales moved up 17.7% in May (after a 22.3% decline in March/April), and the unemployment rate fell to 11.1% in June, from a peak suspected to have been near 20%. Case closed.
If only it was that simple."
Source: Howard Marks Time for Thinking: Aug 2020
As is illustrated in Marks’ metaphor, governments around the world physically mailed money to their citizens in a desperate bid to keep the economic taps flowing. Most people I know have stories of young adults who are staying home and happily accepting their $2,000 monthly CERB payment but have limited opportunities on where to spend it. Our last IMI (The FOMO Rally) discussed how these young individuals were diving into the market for the first time and trying their hand at day trading, despite the overwhelming evidence that for most it is a fool’s errand. (Source: 1 , 2) The impact on the markets from all this ‘Free Money’ has undoubtedly been felt, specifically in the big name Tech Stocks that are favoured by DIY investors and has contributed to the meteoric disconnect between Main & Wall Street.
There-Is-No-Alternative or TINA for short, is another major contributor. Following cuts to interest rates by central bankers around the world, high interest savings accounts are yielding next to nothing for investors. Where we were once getting 2% on our dollars, most Canadian institutions have dropped their rates to less than 0.4% on their top-tier accounts. This rate cut means that for every $10,000 in savings, the average Canadian can expect to earn a whopping $40, pre-tax.
Bonds may be an even more chilling prospect for serious losses. Many Canadians are unaware of their risks in their bond portfolio, assuming this ‘lower risk’ investment protects them against drops. However bonds are negatively correlated to interest rates, which means that when interest rates drop, bond prices go up – and of course, vice versa. We intend to write on this topic in the near future, but suffice to say that according to our own recent research, a 1% rise in interest rates translates into an 8%+ loss for most Canadian Bond investors…
Gold is also often viewed as an alternative to stocks and bonds, however its meteoric rise this year (+29% at the time of writing), causes many to worry that the smart money has already been made.
Alas for many, these factors only leave stocks… In other words, TINA.
As a side-note to the investors with holdings in our Private Pool, we are fortunate to have more options on the table which explains, in large part, our 30%+ exposure to alternative investments like apartment buildings, long-term care facilities, agricultural land, infrastructure, etc.
Last but certainly not least is the fact that although stock market indices have shot up, the flaws in the way the indexes are constructed can create massive dislocations. We have written on this subject before in IMI #54: The High Price of Low Cost. Simply put, as a single company increases in value, it captures a larger portion of the index, regardless of its actual economic clout. In other words, the S&P500 and the NASDAQ are not built to reflect the economic impact of a company, but rather its growing stock market capitalization.
To many, investing in the S&P500 is assumed to reproduce an investment in the 500 largest US-based companies. In actuality, with today’s hyper-concentrated market, 50% of that investment is spread across 5 stocks while the other 495 companies share the remaining 50%.
Source: Canoe Financial Newsletter: August 28th, 2020
Between them, department stores (0.1% of index, 2.15M employees), airlines (0.18% of index, 0.5M employees ) and travel services, hotels, resorts, and casinos (0.18% of index, 16.7M employees ) make up a hair over one-third of one-percent of the S&P500 , despite employing almost 20M Americans, or 10% of its employed workforce. Conversely, the 5 companies that make up 50% of the index employ the following:
Amazon : 1,000,000 worldwide
Microsoft : 151,000 worldwide
Apple: 137,000 worldwide
Alphabet (Google): 119,000 worldwide
Facebook: 52,000 worldwide
For a grand total of approximately 1.5M people worldwide.
In short – the S&P500 no longer represents the U.S. economy as a whole and so its performance should not be used as a gauge for the economy.
How does this impact us?
We continue to believe that nimbleness is imperative in this market. We continue to review the asset allocation of our private pool and that of each individual investor to help improve outcome through these uncertain times. By tactically shifting between cash, stocks, bonds, gold, and alternative investments, we hope to continue to weather the storm and protect profits as the “patient’s” long road to recovery continues.
Thank you for your continued trust.
J-F, Cliff & the Innova Team
Aligned Capital Partners Inc.(ACPI) is regulated by the Investment Industry Regulatory Organization of Canada (www.iiroc.ca) and a Member of the Canadian Investor Protection Fund (www.cipf.ca). Investment products are provided through ACPI and include, but are not limited to, mutual funds, stocks, and bonds. Please contact Jean-François Démoré or Cliff Richardson, or visit https://invest.innovawealth.ca for additional information about the Innova Tactical Asset Fund. All non-securities related business conducted by Innova Wealth Partners is not as agent of ACPI. Non-securities related business includes, without limitation, fee-based financial planning services; estate and tax planning; tax return preparation services; advising in or selling any type of insurance product; any type of mortgage service. Accordingly, ACPI is not providing and does not supervise any of the above noted activities and you should not rely on ACPI for any review of any non-securities services provided by Jean-François Démoré or Cliff Richardson.
Information has been compiled from sources believed to be reliable. All opinions expressed are as of the date of this publication and are subject to change without notice. Content is prepared for general circulation and has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The information contained does not constitute an offer or solicitation to buy or sell any investment fund, security or other product or service. Past performance is not indicative of future performance, future returns are not guaranteed, and a loss of principal may occur. Content may not be reproduced or copied by any means without the prior consent of the author and ACPI. For current performance information, please contact Innova Wealth Management of Aligned Capital Partners Inc. Important information about the Fund is contained in the offering memorandum which should be read carefully before investing.