2020 continues to throw curveballs at the world, and especially financial markets. The economy and the stock market have become decoupled. In this historic time, we have seen historic stimulus from the congress and the Fed, leaving behind news events and stories that would normally drive the market lower. China trade deal falling apart, historic unemployment levels, the VIX remaining elevated, and now widespread civil unrest. But we can’t deny that the market is going higher, so we need to adjust.
Why, and how is the market moving higher? Its simple supply and demand. If there are more buyers than there are sellers, than prices go up. The market is not the economy. The stock market does not read the newspaper, the market doesn’t know about current events. The market meanders up and down unaware of the nation’s political ups and downs, or about geopolitical sword mongering halfway across the world. The market is simply a collection of bids and offers, and most importantly price. Now how the bids and offers move, that is of course a different story. In a bubble, all news no matter how bad is perceived as good. The equity market goes about its path, unaware of any of the troubling headlines we read in the papers. However, the VIX is still elevated. This is telling me two things, 1) the market might be decoupled from the economy, and bad news, but It is paying attention to it. While the stock market rose on Friday and Monday, the VIX also rose; perhaps some risk being put into the protests stalling the economy. #2) The market is not complacent. While the market is happy to continue going higher and allowing higher valuations, the market is worried about a sharp change in sentiment, turning things around fast.
The market is a like a newborn baby, containing all the knowledge in the universe, and completely oblivious to the troubles and worries of a nation. Raising a baby in the middle of a pandemic has been a grounding experience. My second daughter, Abigail was born December 19th, 2019. Her first few months on earth have been confusing time for everyone, and especially for the markets, Starting with the pandemic and then the economic fallout, China shut down its economy in Jan, Japan and Korea in Feb, while the US stock market continued to climb. Then there were U.S. protests on the economic shutdown, and now Abby had a hard time sleeping, my older daughter 2.5 had a sleep regression, my wife and I managed as best we could for the first two months, developing a dependency on coffee and increasingly trying new methods of caffeine. Being a baby is hard, there is acid reflux, colic, hiccups, and burps, and you are completely dependent on care givers for all your needs. When the quarantine started hit it meant, by practice I would be spending more time in closer quarters with her. The quarantine did little change to my social life, which going out already was a distant memory for me and the new normal was early bedtimes and the occasional Netflix show.
The quarantine did ground me closer to my family. And for the first few weeks it was rough, just like the markets. Sleep was even harder to come by, emotions were full of fear, and worry. But I would look at Abby, with some jealousy, and think about how she is going about her life without any clue about the outside world. She isn’t aware of essential workers, of ventilators, of PPE, she doesn’t know about social distancing. She is not aware of Chinese misinformation, or price gouging.
As the weeks rolled on into late march we can remember how dire the situation felt for the market, and for the economy, when the jobless claims were just starting to roll in, it was completely off the charts, and volatility was seemingly endless, with exhausting moves up and down every day and every week. Amidst the chaos, my daily moment of Zen was to play with Abby. I could forget the outside world and just look at her. To be able to smile at her and get her beautiful smile back. Looking at her cute face gave me confidence that I was on the right path. As the quarantine weeks grew on those sweet baby smiles turned to the sweetest little baby giggles. With those giggles, psychology shifted in the market. The buyers emerged, and the sellers disappeared, and the collection of bids and offers started to rise.
As the outside news continues to get worse, Abby continues to grow. Even though we have our problems, here in the US and around the world, we are continuing to grow. The U.S. is launching astronauts into space, pharmaceuticals in the middle of their own space race advancing the biotech industry tremendously, and technology continues to advance on itself.
Remember in 1968, with Vietnam, and the Martin Luther King Jr assassination, and women’s rights movement, America was able to advance. We will advance again. In the meantime, with all that unrest, the S&P 500, with a lot of volatility, managed to return 10.8% in 1968, only to begin a one and half year bear market starting in 1969. 1969 was characterized by fewer riots, and landing a man on the moon, but good feelings don’t buy stocks.
So how do we react? Historically investors have turned to high grade bonds, and low vol stocks. Low volatility stocks are typically value stocks with low PE ratios. Both bonds and value have serious issues. But right now, the low PE companies are the weakest. Such companies are either not prepared or suited to change in the Covid-19 virus economy or they have balance sheets that are so weak they can’t sustain one or two bad quarters.
Somethings matter in life more than others. Just like some things matter to the stock market than others. The quarantine has reminded me connection to loved ones is more important than some of the activities I have been missing. For the market, the bond market liquidity matters more than the dire economic data. Is there a better approach than just buying the market and hoping for the best? In my view, yes, it is active management combined with a hedge component. Selecting stocks that have strong balance sheets, to take advantage of low yields, and selecting stocks that will thrive in the current economic conditions will be able to outperform in this extreme condition. All the while prepared with a long volatility component which can take advantage of market dislocations.