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The Dow Jones Industrial Average and S&P 500 Index are only down 8% on the year, happening at the same time the economy is seeing the worst economic slowdown since WWII. The Nasdaq is up 8% year-to-date (YTD), and it’s not even June — on pace for yet another great year for the index. So, what is happening here? Well, we know the market is not the economy, and large cap stocks are getting a tailwind from the fiscal and monetary stimulus. On the other hand, in my opinion, we are not out of the volatility headwinds by a long shot as global economies and financial markets face record unemployment numbers, sluggish growth, and record low commodity prices due to the Covid 19 virus. That is precisely why I think incorporating a volatility overlay in your portfolio for diversification is critical.
One unexpected bright spot for the economic recovery has been work from home productivity. Companies who have employees working at home have found they can operate just as well if not better than before, and worker productivity is much better than expected. That said, there are still major roadblocks to get over. We are only two months into the crisis and the commercial real estate crater has not really filtered itself into the system. The Federal Reserve bank is pleading with Congress to do more fiscal stimulus to help out state and local governments who had a significant drop in tax revenues. Thus, cracks in the system are still vulnerable and cracks in specific areas could be bad for that particular sector. Single stock analysis can help make a portfolio look more like the Nasdaq 100 Index and less like the Russell 2000 Small Cap Index. Proceeding with caution and due diligence on parts of the economy is necessary.
Nevertheless, I do think we can innovate our way out of this problem. I believe the American system of free market capitalism is the best way to do so, and the reason why money continues to invest in America. As a result, I’m willing to invest with full confidence that the market, and I am supremely confident major U.S. equities will be higher given a long enough period. However, the risks to shocks in the system can cause significant “hiccups” in the market, which is why I am always long the market with a hedge.
A perfect example of a hiccup in a single stock happened recently. The market was eagerly the recent news surrounding a vaccine and the company, Moderna. Early last week, Moderna released partial results of an early vaccine trial, a day ahead of the companies one billion plus capital raise by the company’s capital raise. On the surface, this is a perfect use of capital markets and why I love capitalism. There is a global problem with Covid 19, and Moderna might be close to the solution, but if they do have an effective vaccine in their next trial, they will need to vastly increase their production capabilities. This capital raise will allow them to invest in facilities to ramp up production and do so fast. The market priced the offering extremely high, expecting the stock to continue its meteoric run. After the offering, the stock traded down 10% on doubts cast on the limited test and spooked the stock market lower, temporarily. Optimism quickly returned and I think cooler heads prevailed that of course data is limited in Phase 1 trials, so let’s wait until Phase 2 to make any judgements. Also, the liquidity in the system was enough to shake out the weak hands and move stocks higher the next day.
These volatility events that seem to be happening more and more frequently allowed for hedgers to rebalance into stocks lower, so I like having that aspect of investing right now as a sleeve of my investment portfolio.
So that’s a lot of optimism. Here is a dose of reality. As confident as I am about us markets, I am equally confident that there will be shocks to it, just like the shock investors in the secondary offering to Moderna last Tuesday. Just going back the past few years, the following comes to mind: December 2018 was a trade war, February 2018 there was “volmaggeddon” Brexit, the 2016 election, the 2015 taper tantrum, the 2012-2013 fiscal cliff, I can go on, but you get my drift. These events cannot be predicted precisely, but it’s more likely than not that a volatility event will happen in a calendar year and that is why I maintain a volatility overlay in my portfolio to add diversification.
