Michael McCracken CFP®, ChFC
Stocks and COVID-19, Does Anything Make Sense?
As your financial advisory team, we want you to know we have been working hard to navigate the market through these unprecedented times. Markets have been rattled and moved sharply lower beginning in late February – March 23rd based on fear and uncertainty in response to what we now know as COVID-19. We were able to hedge the market during this time and stem the losses to some degree – yet, as the market has been in a rally mode since March 23rd, this behavior has been a major challenge to us. Our goal in this blog is to shed some light on what we see and why we have been so defensively allocated for the past two months.
First – We use hedges / defensive setups to soften the blows when we believe major selling is or will hit the market – primarily when in sync with over-bought conditions or valuations that are stretched beyond what makes sense to our team based on fundamental and technical analysis.
Second – History is a great teacher in our research process which we will try to illustrate through a few links – with charts included – often a picture is worth a thousand words.
Third – Why have we been concerned and defensively invested during this momentum-driven recovery? Corporate earnings have been hit very hard and, as a result, based on forward looking Price / Earnings Ratios – stocks are trading at prices relative to their earnings that are in many cases, quite over-valued. History suggests that many stocks may be trading (based on fundamentals) in bubble territory.
So why are many stocks creeping up in value when by most analysis they are at the very least fully or more than fully valued? We believe it is due to a combination of the US Treasury and the Federal Reserve (FED). Through their very aggressive action, they’ve convinced those buying up the market that they will keep it on a solid footing. The FED has gone so far as to communicate that they have unlimited resources and through a newly created tool called Special Purpose Vehicles (SPV) – they are actually one of the buyers – primarily buying high yield bonds. Details The saying ‘never fight the FED’ has certainly played out for the past few months.
Buying securities based on the moral hazard idea and what the FED is doing goes against everything I’ve ever learned in my 30 years of working in this industry. I’m concerned that many doing it have forgotten about the risk involved. I remember all too well how the market acted in March 2000 when valuations became so very stretched. People were claiming there was a new economy and method to value companies only to find out that indeed fundamentals still matter and eventually will come back in line. The dot-com bubble popped and people who were not prepared lost a fortune.
Take a look at these charts showing a valuable picture of the relationship between stock prices and earnings. Click on the following link: S & P historic P/E ratio
Now – relate the previous content to the following chart of the S&P 500 index during the same years. The top chart is the Shiller Cyclically Adjusted PE Ratio – the same thing seen in the link above. With the S&P 500 index in the lower chart going back to the 1950’s.
This is a new experience for most of us for sure. But at the end of the day, stocks need to make sense and P/E ratio’s matter. So, yes, we have under-performed the past two months as a result of being hedged (which is why we outperformed during the 1st quarter). Our current allocation has a healthy cash position, so if valuations come in line, we will certainly put it to work. At this point either earnings need to increase substantially, or prices fall significantly relative to the average on the S&P 500.
There are individual stocks that are performing very well in this new COVID 19 world – and you own some of them – so our commentary is based on the average in the index.
Treasury department continuing to print money
Debt going through the roof
Vaccine - hope for a rapid solution is one of the driving forces behind the rally.
The bottom line is this season will end and we will continue to work diligently to maximize every opportunity it presents for us to win. We are so thankful to be your advisor and felt it necessary to communicate our understanding of things. We take our responsibility very seriously and want you to know that although this has been an unprecedented challenge, we are embracing it.
Authored by: Michael McCracken CFP®, ChFC and Jeffrey Gardner, Financial Advisor The information presented above has been prepared for informational purposes only and the commentary represent the opinions of the author and are subject to change at any time due to market or economic conditions or other factors.