• Stephen Hanley

Q3 2020 Market Update

Quarterly Market Recap

The third quarter continued this year’s rebound with the Wilshire 5000 index gaining 9.01% from the timeframe of June 30th through September 30th, resulting in a gain of 4.85% year-to-date (1).

The Aggregate Bond Market, as measured by the Barclays Aggregate Bond Index, had declined -0.13% in the second quarter, but as of September 30th, the Aggregate Bond Index has moved up 5.06% for the year-to-date (2).

Our investors’ accounts have weathered the storm as expected, with most bouncing around break-even for the year. As we move past election uncertainty, we hope to see a continued economic recovery and increased market stabilization.


Election Thoughts

As of now, Joe Biden seems to be the odds on favorite.  We will likely see a protracted court battle before any final certification is reached.  Hopefully, the process leads to improvement for voting security. It is vitally important we have a system we can all trust. Regardless of the final outcome, we hope the courts can lend some improvement to the current voting process.

As of now, the equity markets are reacting very favorably thus far, with the S&P 500 up almost 7% since 11/2 (intraday, November 10th).  With election results starting to come in focus and the successful Pfizer vaccine data, the unknown variables are decreasing. As markets absorb more information, the certainty level of possible outcomes increases. With a split congress, the market assumes many ‘extreme’ changes in regulations become very low probability, while the possibility for add-on stimulus has increased. This allows us added confidence in owning many companies that had been at risk from regulatory changes by the government. For example, a company such as United Health is now less likely to face headwinds from a healthcare overhaul. Lockheed Martin is less likely to face massive budget cuts. Google is less likely to face anti-trust law pressures. Big changes may still be coming, but for now, the market appears to feel more confident about fewer regulatory changes occurring over the next four years. As I’ve echoed during every pre-election article, post-election certainty is usually a positive for the markets regardless of the results.

Strong Economic Bounce

The third quarter saw a tremendous 33% rebound in GDP (Gross Domestic Product), to bring our economy somewhat back to ‘more normal’. It remains to be seen if this bounce is sustainable. The government stimulus programs have provided added fuel to the rebound, so we’ll need to wait a few more quarters before declaring the economy fully recovered. We’re cautiously optimistic that as the world eventually returns to more normalcy in 2021, that the economy will be able to ween-off the government stimulus and stand on its own two feet yet again.

Valuation Concerns?

Within this solid rebound, we’re noticing some areas of the market that look stretched. Areas like software application have become a bit too hot to handle and serve as a good proxy for our observations. As a whole, the software application industry sells at a P/E (price-to-earnings) multiple near 75 with 3% profit margins, 1% earnings yield, and $2 trillion dollars of market capitalization (many companies sell at no P/E because they have yet to make a profit). These numbers should raise a red flag. While we believe some great companies exist within the software space, the competition is quite fierce. The revenue growth story of these companies may be strong in the long term, but companies must eventually convert a future promise into real cash flow for sustainable value to be achieved.  

We believe these valuation warning signals point to possible ‘over-exuberance’. Similar to the dot com bubble of the late 1990s, we’re beginning to see a disconnect between the returns of many tech companies and the reality of their business fundamentals. However, we’re still in the early innings of the game. So far, this disconnect hasn’t become systemic in nature, but it does appear to be building momentum. In the late 90s, we saw many investors abandon sound investment principles in favor of ‘hot’ technology stocks. It was a period when the story of a company was more important than any cash flow they produced. The recipe for extreme exuberance and asset bubbles is generally found with a few core conditions. These include: cheap money (low-interest rates), merging technologies (hot new story), greed, and forgetfulness of the past (that won’t happen again), and ‘new math’ for calculating the value of these investments. We’re beginning to see these late-90s themes re-emerge now. In the days of Robinhood trading platforms and millennials whom never experienced the pain of the 1999 collapse, it wouldn’t surprise me to see a similar 2000-like run-up in the market and a subsequent correction sometime in the next five years. Thankfully, we’re not seeing these speculative trends yet; these themes haven’t become market-wide. It often takes years for bubbles to build, and this factor should allow us adequate time to maintain proper diversification so our portfolios aren’t hurt. Nonetheless, we’re keeping a close eye on these growing trends relative to valuations. 

Inflation Concerns?

YES. We mentioned in a prior article the long-term hazard of inflation. Whenever things are really good, you must be aware of inflation rearing its head. It’s hard to imagine we won't have above 2% inflation at some point, but ultimately the FED has many tools to control it. We’ll keep a close eye on inflation as the economy rebounds. Inflation has already been factored into our asset selection and favors capital-light investment that generally has larger margins and a higher return on capital employed. This inflation fear may also add fuel to an asset bubble in certain areas such as technology. We’re keenly aware of the damages that inflation can unleash on a portfolio. Nothing has stolen more money than inflation; not taxes nor government regulations have compared to the dangers of out-of-control inflation. We hope the government and the Federal Reserve can properly rein-in spending after a full economic recovery has taken place.

Conclusion

Over the past few quarters, we’ve repeatedly stated that stocks need to be a large part of your portfolio to maintain real purchasing power. We struggle to see how fixed income products such as bonds at 2-3% can offer any real return when inflation is now being targeted at OVER 2%. It could be a slowly draining tub for portfolios that have extreme fixed income in the long term. Of course, this thought process is exactly what could also lead to large volatility in the equities markets. The next 10 years may prove much choppier than the last 10. To manage the volatility with higher confidence, we continue to feel high-quality companies with strong balance sheets will drive a premium and be very important in years to come.

We shared a quote during recent quarters that has proven to be very accurate:


“Stock market looks high, is high, but not as high as it looks” – Benjamin Graham Quote

With interest rates incredibly low, tremendous amounts of money waiting on the sidelines to invest, few alternative investment choices to equities, and perhaps…fingers crossed…an eventual return to normalcy; a continued melting upward for stocks may very well continue for the time being.

As always, regardless of price direction, we remain laser-focused on owning great companies through proper diversification to meet your long-term planning needs.

We hope this article adds some value, answers some questions, and perhaps gives you a little extra peace during this unique period in history! It is a tremendous honor to help steward your assets and retirement journey during this time. Thank you for your trust!




(1) Data reported by Folio Institutional. (2) Data reported by Y-Charts Data, www.ycharts.com.

The Aggregate Bond Market, as measured by the Barclays Aggregate Bond Index, had declined -0.13% in the second quarter, but through September 30th, resulting in a gain of 4.85% for the year-to-date (1).ear-to-date (2). (2).


Evergreen Wealth Management, LLC is a registered investment adviser.  Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.  Investments involve risk and unless otherwise stated, are not guaranteed.  Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.

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