In a period where our routines have been severely disrupted, and our ability to travel, attend events, or even make plans has been severely hampered, days frequently run into one another. It turns out that psychologists have a term for this disorientation: “temporal disintegration”. While it stands to reason that a dramatic interruption of our normal schedules would give rise to this lost sense of time and sequence, experts also believe these effects are compounded by a lack of certainty about the future. This notion resonated with us as we reflected on the events of the second quarter of 2020, and how we might make sense of what transpired over a 90-day period that at various times felt both quite longer and quite shorter than that.
Thinking back to the beginning of this quarter, though markets had stabilized somewhat from the chaos of late March, the recovery rally was still tentative at best. While it was clear by that point that both the monetary and fiscal response to this crisis was going to be meaningful, the speed with which it reinvigorated market sentiment was unprecedented. By early June, the S&P 500 managed to erase its year-to-date losses after its best 50-day rally in history. Though by month’s end it would give back some of those gains, this did not prevent the index from having its best quarter since 1998, rising nearly 20% over the period. For some context, annual returns for the S&P 500 have been higher than that only four times in the past decade, and the second quarter of 2009, the first full quarter of the market recovery from the last crisis, saw “only” a gain of 15.9%. With that mind, it appears to us markets did a good job compressing time this quarter, fitting what frequently represents a year’s worth of returns into a mere three months. If we did not know any better, it would seem markets are themselves suffering from some form of temporal disintegration.
This phenomenon was not limited to U.S. equities, with most developed and emerging markets posting returns which, though somewhat less dramatic, represented a meaningful recovery from the depths of March’s rout. On the fixed income side, credit spreads tightened throughout the quarter as central bank asset purchases provided assurances to investors in corporate debt of both investment and speculative grades. Emerging market sovereign debt also saw spreads tighten, while central bank rates in most developed economies remained unchanged from their low levels. Overall, the prospect of a so-called “V-shaped” recovery had gained so much credence that it almost appeared as though markets were skipping the trough of the cycle and moving right on to the expansion of the next one. In some ways, this lost sense of sequence is arguably symptomatic of the affliction we have discussed.
Admittedly, not everyone chose to ignore the death of the last economic expansion, which, as a side note, was the longest in U.S. history at 128 months. In early June, economists at the National Bureau of Economic Research made the call, formally declaring the U.S. economy in a recession. Earlier on in the quarter in May, Germany, after revising its Q4 2019 numbers, did the same. If the data seen over the past few months is any indication, most of the world’s major economies will soon be declaring recessions as well. Granted, the news was not all bad, with many taking a declining unemployment rate, rising activity in the manufacturing and service sectors, and improved consumer confidence numbers as signs that this recession would be short-lived. However, as we have highlighted in the past, the unique nature of this situation leaves us all flying blind in some respects when it comes to data. This was reinforced by the recent release of the June report from the Bureau of Labor Statistics: though the unemployment rate fell once again, depressed survey response rates, significant classification errors, and a persistent disconnect with state unemployment insurance filings all suggested a great deal of uncertainty around the headline number. Quite simply, the real rate of U.S. unemployment is anyone’s guess, a testament to the unique degree of uncertainty with which we are all contending at the moment and may have to contend with for the foreseeable future.
Indeed, we find the high level of uncertainty to be the most interesting element of this environment. As we discussed at the beginning of this letter, psychologists believe a lack of certainty about the future can compound the effects of temporal disintegration. Perhaps this explains, at least to some extent, the recovery in risk assets over the course of the quarter despite persistent volatility and unabating risk overhang from the global pandemic, which is nowhere close to being resolved. As we have seen since mid-June, parts of the U.S. which were quick to reopen appear to be contending with a new surge in COVID-19 cases and are now finding themselves forced to reinstate shutdown measures. With other countries and regions experiencing similar flare-ups that are hampering the reopening process, it would appear that a return to pre-COVID levels of economic activity may take far longer than expected. Yet in a world where our sense of time is somewhat distorted, perhaps the phrase “longer than expected” carries little meaning, thereby in some ways justifying the market’s recent upward trajectory.
At the same time, others have taken an Occam’s Razor approach and attribute the impressive performance of this quarter to the actions of the Federal Reserve and other central banks. However, we find this to be a somewhat unsatisfying explanation. Loan programs can help keep businesses afloat for a time, but a sustained lack of demand likely results in downsizings and even closures. Bond buying may prop up capital markets, but does not necessarily prevent defaults by overleveraged, distressed firms. Even fiscal stimulus efforts, including direct payments to consumers, are of little consequence if they are merely hoarded due to fears about what the future may bring. We are not the first to question the efficacy of this deluge of liquidity being pumped into the system and indeed would have a difficult time conceiving of what further action by central banks would really accomplish. While interest rate cuts and asset purchases can keep capital flowing and asset prices elevated, there are limits to the simulative quality of these efforts in the real economy, and the disconnect can only last so long.
Not all corners of the market have been displaying this disconnect, however. Recently, we have been paying close attention to the distressed debt space, which appears to be signaling a road ahead more fraught with peril. While credit markets have stabilized since March, bankruptcies are clearly on the rise. On average over the last twenty years, there have been roughly 120 U.S. bankruptcy filings with liabilities greater than $100 million in any given year- as of the end of Q2 of this year, we have already surpassed that number. If this pace were to keep up for the rest of the year, it would make 2020 the worst year for bankruptcies since 2009. That is bad enough, but some have posited this trend may accelerate in the coming months, due not only to ongoing economic softness, but also due to some of the perverse incentives that came with early aid programs like PPP. While it is difficult to say how much better or worse things will be in the second half of 2020, it is clear that there will be no shortage of work for bankruptcy lawyers and restructuring advisors in the years to come.
Source: Bloomberg (as of June 30, 2020)
Given what appears to be an increasingly precarious economic outlook, we continue to believe that in general equity valuations look rich. However, let us assume for a moment that we were willing to underwrite our investments to a speedy return to the level of economic activity seen at the beginning of this year. Even at that time, we were expressing serious concerns about stretched valuations, especially in U.S. larger cap equities. Flash forward back to today, accounting for everything that has occurred in the first half of the year and the uncertainty of the path ahead, and the picture looks decidedly worse. Some have argued that in a world where ultra-low interest rates translate to paltry returns on most fixed income instruments, equities at least look attractive on a relative basis. While this point is well taken, we also feel that equity valuations are failing to account for a potentially protracted period of anemic global growth. Such a scenario is far from out of the question, implying the risk-adjusted return offered by the equity market in the aggregate, even on a relative basis, may not be as compelling as it seems.
Source: Bloomberg (as of June 30, 2020)
While valuations unseen since the late 1990s or early 2000s give us pause, perhaps even more concerning is a seeming return of some of the worst behaviors from that frothy period. Yet again, we see a contingent of retail investors engaging in risky day trading strategies, stock prices taken to lofty new heights based upon speculation as opposed to fundamentals, and the return of “pre-revenue” IPOs. Yet another aspect of this environment reminiscent of the “Dot Com” era is an investor infatuation with technology companies of all stripes. Information Technology companies now represent nearly a third of the S&P 500 index, approaching levels last seen nearly two decades ago. With the sector trading at roughly 20x EV/EBITDA, a level unseen since 2001, we cannot help but wonder whether investors may yet again be overpaying for glamorous, technology-focused businesses with uncertain prospects for growth.
Source: Bloomberg (as of June 30, 2020)
While a return to the bad habits of old is unsettling enough, perhaps even more confounding are some of the new phenomena we have encountered in this period. We have seen the gamification of day trading through brokerage firm mobile apps, many of which are more than willing to extend generous margin to inexperienced customers. These neophytes frequently engage in downright bizarre behaviors, including plowing into the shares of companies which have already declared bankruptcy. Car rental giant Hertz sought to capitalize on this trend, making an unprecedented attempt to raise equity capital right after filing for Chapter 11 bankruptcy. Though the company disclaimed that there was “a risk that the common stock could ultimately be worthless”, we doubt many potential investors would have heeded this warning had the deal been allowed to go through (the SEC ultimately intervened, demanding further review of the offering). Needless to say, calling these times strange would likely be a gross understatement.
With all of this in mind, we continue to believe it prudent to maintain a defensive positioning in client portfolios. Risk assets may continue their ascent, especially as many investors, fearful of missing out on the action, increasingly throw caution to the wind. However, we are concerned that markets (and their participants) may indeed be suffering from a degree of temporal disintegration. Despite the fact that we may not be anywhere close to the end of the economic havoc wrought by this pandemic, equity valuations are at a level last seen in a period where GDP growth was averaging over 4% per annum. This either suggests that the recovery from this crisis will be far swifter, smoother and stronger than consensus, or that markets have, as they are wont to do, gotten ahead of themselves. In our eyes, the latter case is the likelier one, and we have positioned portfolios accordingly.
With that being said, we recognize that situations and viewpoints vary, and we welcome dialogue with our clients on the issue of positioning. If you are of the belief that your portfolio requires an adjustment of risk exposure (higher or lower) based upon views of the future, your needs, or your risk tolerance, we strongly encourage you to contact us.
We greatly appreciate your support and trust, especially during what have been strange times not only in markets but in our daily lives. In case this has not yet been emphasized enough, we feel it important to keep the conversation going: should you have any questions regarding portfolio positioning, markets in general and our outlook going forward, do not hesitate to reach out to setup a time to talk.