Capitalism; going, …. going, ….
“Got your back”: The US Fed has led a global charge to lop the bottom off the business cycle. Many business actions today would not be contemplated if there were repercussions from getting it wrong. But players are being protected from negative consequences, and it is arguably eliminating capitalism’s creative destruction and misallocating capital. Yet the equity market doesn’t mind. The “Fed’s got your back” and “don’t fight the Fed” are handy and appropriate taglines for stock market bulls.
Onward and upward: A combination of boundless liquidity and near zero interest rates have provided a firm floor for asset prices. To the point where bad economic news often turns out to be good news for stocks. If something goes wrong your friendly neighbourhood Central Banker will “do something”, right? It leaves traditional, old-fashioned investors who rely on quaint notions like fundamentals scratching their heads.
“Rational” zombies: We believe the stock market is being rational with the cards it has been dealt. The most important price of all, the interest rate, has been manipulated along the entire yield curve. Stock price multiples have climbed as a result, while investment alternatives have disappeared. Efforts to eliminate business cycle troughs have extended into financial markets and we would argue here too price discovery on the downside is being blocked. There are zombie companies out there. Perhaps zombie investors too, but that doesn’t mean they’re irrational. They’re just playing the game.
Wall Street vs Main Street: Is it a dangerous game? Modern Monetary Theorists may argue otherwise but we stick to the “no free lunch” adage. Growing debt and unnatural price discovery comes with risks. While the “risk-free” rate may have fallen, the “market risk premium” has gone up and has gone largely unrecognised (ignored?) in our view. Further, the unintended consequence of propping up financial markets is the widening gap between the “have’s” on Wall Street and the “have not’s” on Main Street. Friction, polarisation and angst are intensifying, compounding economic and financial risks.
Equity investment view
There is little choice but to remain invested. Interest rates are not going up anytime soon and further monetary easing is likely. This will continue to prop up Wall Street (even if it does little for Main Street). But risks should be acknowledged and taken into account in equity portfolio construction. COVID-19 “recovery” and “back to work” stocks may offer the most upside after losing the most, but come with greater risks.
We believe there should still be decent exposure to “stay at home” stocks and good quality companies with little debt and strong cash flows. This should reduce downside risk while still offering some upside. Finally, it’s curious the “risk-on” surge in equity markets has gone hand in hand with firm gold prices. Perhaps more than a few investors out there think a bit of gold insurance is a plan. A good idea in our view.
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