Town Hall Recording 7/16/20
Live Market Update Call 7-16-20
Maureen: Welcome and thank you for joining HCM’s call with Doug Johnson and Mike Hengehold. Today is July 16th, on this call Doug and Mike will discuss the market as both a voting and weighing machine. The corporate earnings game and its impact on price, and how current policies may affect portfolio construction going forward.
Your lines are muted. We ask that you please keep your lines muted and send your questions into our email box at firstname.lastname@example.org. We will address any questions that come up through our email as best as we can during this 30-minute call. I will now turn this over to Mike and Doug, Mike.
Mike: Hello everybody, this is Mike and Doug. So as Maureen said, one of the things that we want to do, sort of have a bit of a theme for the call, is to talk about the market as a voting or weighing machine. This sort of concept, it's actually a quote from a sort of big-time historical investor and economist gentlemen named Ben Graham. He was so influential actually, that Warren Buffet named his oldest son after Graham, who was also one of Warren Buffett's professors. So, it's interesting in that regard. But again, the concept here is that when we talk about the voting machine and the weighing machine.
That in the short run, the market is a voting machine. In the long run, it's a weighing machine. Essentially the voting machine is weighing the sort of emotional reaction that people have to news events of the day. That's where we get the big price swings on a short term basis, the spikes and the troughs. If you think about it, since the covid issue broke out in early February, the market was, an almost speaking for the Dow, for example, was it around 30,000, something like that? It fell about 35% in the sell off. And then immediately turn and rallied back up again. As investors reacted to financial support from the federal reserve and, hope for, you know, either a vaccine or better treatments. The market rallied up to a high, I think in June, middle of June, of around 27,000-28,000, it was about 27,500 something like that.
It is now fallen back off again. Today finishing somewhere around the 26,700 range. So, where it sits today is, is roughly 10%, about 9% or 10%, below where it was in the high end February. But so, you can see, it's a rather modest correction from the high, but the traveling between the peak and the trough has been pretty significant. So that's the voting machine operating on a daily basis. And over time, the weighing machine sort of gets, when it has time to collect all the information, gets that sorted out into a more of a fair value.
So, Doug, I ask you, what sort of things are we dealing with today that sort of drive the voting machine that we're concerned about with our portfolios?
Doug: Well, I think there's a lot of topics that we could discuss, and we could probably spend the entire duration of the call doing so. But let's try to focus on a few things, both on the positive and the negative side.
So, the market piece that we just put out yesterday was titled “fear and greed”. And I think that, you know, when we think of sentiment in the market, most of the time the sentiment is, running between two kind of extreme levels. But when we break out of that channel, those emotions can really take hold and caused some extraordinary things to happen in the market.
So, you think back, obviously what started all this was the emergence of a COVID, not only in the U S but globally. We had an intense fear, intense uncertainty, driving prices down. And then, you have the federal reserve stepping in, with unprecedented levels of liquidity. Which was enough to STEM that tide and reverse it.
And then as we've moved higher, you're starting to see some pockets of greed in certain areas in the markets. Specifically, in things like the NASDAQ and tech in general. You know, I saw a Bloomberg article today that had a headline in it that I read it and I kind of had to shake my head. But the title of the article was the fact that, you know, maybe we should be embracing tech valuations right now. But the rationale behind it was that the question around maybe investors can't price things that haven't even been created yet. Which seems like a really, really roundabout way to try to justify some of the things that we're seeing right now.
But you know, I think people have really, you know, kind of embraced the fed and what they're able to do, and kind of run with it. And almost too far, especially considering the backdrop of what we've seen on the economic side. Continued headwinds in the labor market, just today, we had an additional 1.3 million people file for, initial claims on a weekly basis. That's still twice as high as we saw at the peak of the great financial crisis.
Mike: Initial claims for what?
Doug: For unemployment.
Mike: Thank you.
Doug: So, you know how that is going to play out, going forward, to kind of counteract some of this, you know, extreme price movement that we've seen. Is really going to be interesting. And I think, these kind of short term news flows are going to continue to drive prices here in the immediate future.
Now not all is bad. We have seen some degree of positive news. You're getting pockets of economic data that's good. Even though we've seen a spike in COVID cases in several States, hospitalization numbers are continuing to trend down. Deaths are continuing to trend down, so that's a good sign. And then, you know, you're still seeing this constant banner around vaccine data.
So, Moderna came out with some initially encouraging data that they were able to generate antibodies and T cells, that were two to four times higher in their test subjects then what you would see from somebody who was a recovered COVID patient. The issue is, when streaming through the data, that you'll see that the drug actually causes some unwanted side effects for over 50% of the patients. So, it's kind of one step forward, one step back.
You know, trying to find a vaccine that's going to not only be effective and be able to produce, but that doesn't warrant side effects, that in essence could be worse than actually contracting the virus itself.
So, you know, Mike, I know we've talked a lot about vaccines in the past kind of. I'd be curious to get your take on what you think is happening in that front.
Mike: So, what I've been able to learn from, sort of my responsibility and digging into this is that. Most managers for large economic pools, the Goldman's, the JP Morgan's, things of that nature, are essentially investing with the notion that there's about a two month window to get solid positive news on a vaccine solution. And if that does not happen, that the market positions they've taken are at risk, is something that was recently reported on CNBC by Andrew Ross Sorkin, who is one of their financial reporters.
One of the things that I think thats sort of outside of, I mean, we spend so much time talking about the corona virus, that I think sometimes we lose sight that there were other concerns coming into this. And this is sort of overwhelmed the discussion, and the sort of balancing act against all of these concerns was the federal reserve, obviously, but the central banks around the world. Stepping up and taking a sort of “well we'll do whatever it takes” type approach. Which effectively creates a bit of a moral hazard, in that those policies, for political reasons, could be morphed and changed at any time for a variety of reasons.
How do we think about that whole notion of investing based on sort of moral hazards versus the underlying fundamentals of the market themselves? And I guess I would add how do we balance that within the structure of the portfolios?
Doug: Yeah, I mean, I think it puts everybody in a tough spot because, you know, you don't necessarily want to think that fundamentals don't matter at all, that earnings don't matter at all, that any of this economic data doesn't matter at all. As long as the federal reserve is willing, and I guess able to, step in and support asset prices.
Now I've even heard people term the phrase, that we may not even have a free market anymore, price discovery doesn't exist. That's a philosophical debate that I think you could spend an hour going over whether or not that's accurate. But I think the reality of the situation is that this is the environment that we're in right now. And the challenge for us, and I think the challenge for everyone, is trying to strike a balance between seeing the headwinds and the uncertainty on the economic and COVID front, and balancing that against the kind of upward trend that we've seen in the market.
You've heard us talk about technicals and market internals before. And those have improved pretty substantially since the beginning of this has happened. Now, you know, prices go up, that's naturally going to follow. But we've reached some critical points to where historically, when you get to these levels and you get these internal signs in the marketplace, the probability of having the rally be sustainable is actually pretty high.
So, respecting both sides of those things and trying to, not only participate in the up move, but at the same time, not taking too much risk considering everything that's going on right now. I think that's the challenge that we're facing right now. I think that's a challenge that investors all over the place are facing, is how to balance that, the best we can. I think for the most part, it's going to have to continue to be data dependent with the way that the news flow has been. What might sound reasonable today might not sound reasonable two weeks from now. You don't want to be that myopic and that short term focus, but in an environment like this, you have to really consider all of those avenues.
Mike: So, in that discussion you mentioned the fundamentals and so forth. We find ourselves this week sort of the opening volley of earning season. And of course, there's a great dance that goes on in preparation for earning season. And then as things play out with regard to companies meeting, beating, or falling low expectations. Want to talk just for a few minutes since that's sort of a real-world present day event?
Mike: How that works.
Doug: Yeah. So, we've got earning season, you know, kicked off this week. You had a lot of the major banks that reported some favorable, some not so favorable. Still a lot of the banks are taking large loan loss reserves, on their earnings report. Which basically just means they're putting money aside in anticipation of possible losses, either through people defaulting on mortgages, whether it be residential or commercial, credit card debt, any way that a bank has lent money. They look at that and they say, okay, is there an increased probability that we're not going to get this paid back? And then they set money aside for that.
So, it's been a mixed bag. But I think what you're going to see in this earning season, is that with no guidance provided by any CEO. The analysts are really just kind of stabbing at what they think is going to going to take place. I think most people are expecting earnings season to be really poor on an absolute basis, but the wall street game that's been played, outside of just this time period, is the analysts like to create very high price targets. Initially, you know, six, seven months ahead of time. And then they very quietly reduce those lower and lower and lower and lower and lower and lower. And then all of a sudden it's at its lowest point, right before the earnings are reported. The number gets reported, everybody cheers cause it's a beat and optimism abound. When you look back and you say, okay, the number that they actually reported is worse than the initial estimation.
So, my guess is that you're going to see that happening again, but I think what's more important than the absolute numbers that you're going to see, is probably the guidance. If there is any, around what the situation is going to look like going forward. Because I think everyone's kind of written this quarter off as a COVID quarter, so to speak. But if there's expectation of a V-shaped economic recovery, that can maybe back some of the market moves that we've seen. We're going to have to see progress at the corporate level as well in the upcoming quarters and that quite frankly, it should start to be reflected, from the people who were running these companies.
So, I think if you're not hearing a lot of optimism from some of these CEOs around what the future might hold, it may cause a little bit of volatility in the marketplace. But I say that kind of tongue in cheek, because it hasn't seemed like the fundamentals have matters a whole lot, over the past few months. But we'll see how that this earning season plays out. I think it'll be one for the record books in terms of contraction, but I think a lot of people are already expecting that.
But you know, outside of that, you know, there's another topic that we haven't got to yet that I think is starting to bubble to the surface. And in a normal year, I think people would already be talking about it, but, it's that little event in November.
Mike, if you want to, if you want to touch on that.
Mike: So, obviously the upcoming election has, what would typically have, some significant influence over the election. The biggest concern now, and we want to be careful because the two things you're never supposed to talk about is politics and religion. So, this is pretty much just an objective look and a little bit of historical perspective. But the biggest concern financially is that in order for the market to do well, stock prices are generally a reflection of the expected future earnings of companies and taxes have a, have a big bearing on that.
So recently, you know, since the current administration has come into power, corporate tax rates have been cut significantly. So, that could be no different than cutting their energy bill or their advertising bill. If your expenses go down, they're bigger profits, bigger profits justify higher stock prices. So that's one thing that is a fundamental underpinning of the fact that prices are higher. The Democrats have suggested that if they come in one of the first things they would want to do would be to raise the corporate tax rate from 21% to 28%. So that would be a big negative for the market, just in the simple computation of sort of the discounts involved in a dividend model, which dividend models have nothing to do with dividends, but it's how you come up with sort of a fundamental value for prices.
On the personal side, they are talking about accelerating the increase in individual taxes. So basically, unwinding the reduction in tax rates that came in a couple of years ago, and taking the capital gains tax rates, from the advantage levels that they are now, sort of a 15% tax rate up to a 23.8% rate. Actually, capital gains can be taxed at zero for people in the lowest ordinary income tax bracket. Those rates would be then potentially move moved up to the highest ordinary rate. Obviously to the extent that capital gains have no benefit, there's going to be less incentive to take the risks associated with investing in riskier asset classes. That would also reduce the value of equities and would potentially ripple through.
So, we actually have a question, a client question on this subject in a little bit, so I'm not going to steal the thunder there. But the takeaway here is that regardless of one's politics, there are some financial concerns and they typically revolve around tax policy. That in most traditional valuation models would have a negative impact on stock prices.
Doug I know you did a little bit of homework on how markets react during typical election cycles and so forth. Do you have any of that?
Doug: Yeah, so we can just kind of run through some of these data points fairly quickly. But just a few things to touch on.
So, recessions and major market declines, usually don't bode well for incumbents. So, the natural question is will voters blame the president? For obviously not creating the virus, but the response to the virus, you know, how that was handled and essentially what it did to the overall economy. We've had a pretty big market recovery right now but will that hold into November. The 2020 monetary and fiscal stimulus under the president is the biggest in an election year since, at least, Lyndon Johnson and the great society expenditures. You have post-election rallies have been the strongest, when the Republican party has retained the white house.
So naturally what would a Biden presidency mean? And I think Mike touched on it, the biggest fear that investors would have around a Biden win. Is a democratic queen sleep that directly leads to higher taxes. You know, the market typically has followed a four-year pattern. The cycle, you have a strong pre-election year, with a weak first half of an election year. Now, I don't know that we've ever had an election year that has had these types of things happening concurrently. But, nonetheless it does match up. And then the timing of the second half of an election year, the rally typically depends on when the market identifies the winner.
We've seen some polling come out, that would suggest that the Joe Biden has a pretty big lead, depending on what you look at. But the thing that I always like to point out is that during the last election, I think two hours before the polls opened, Hillary Clinton had a 95% chance of winning. So, kind of looking at the polls I think can be beneficial at times, but they shouldn't be taken as gospel by any stretch of the imagination.
And then lastly, you know, the market is risen at a faster rate when Republicans have controlled Congress. And I think that as well, is a little bit up for grabs in the cycle. So certainly, a lot going on coming up in terms of political news. And like I said, normally we would be discussing, this would be a bigger focus, if you didn't have the backdrop of everything else going on. But in a world of massive uncertainty, it's just another thing to have to consider.
So, Mike outside of that, is there anything else that you think could be a potential risk in terms of elections?
Mike: Well I think, risk in terms of the elections and in these sort of other outlying things that could jump in and cause the voting machine to kind of go wacky on a short term basis. The biggest thing that's been in the news lately, it's tended to settle down a little bit from a headline perspective, but it has to do with a lot of the social unrest that's been flaring up around the country. And certainly, with the conventions coming up with a little bit of historical precedent from the sixties. We know that that can be a focal point. The issue around the convention, whether they're going to be held inside or outside, whether we're going to have big public conventions, if there are outbreaks, there's just a lot of potential things that are going on.
And as you mentioned earlier, we sort of take these as they come. With regard to how we deal with them within the portfolio. So, with regard to that, what I would like to do is jump to a couple of the questions that we have. Here's one that kind of goes, we can kind of tailor the answer, I think a little bit into that issue.
So, a question came in and said, can you review the differences between the strategic in the advanced and defense strategies? So let me take the first part of this, and then maybe you can jump in on the second part, what the particulars on some of the portfolios themselves.
The strategies are, the thing that distinguishes them, are how we handle the rebalancing and the investment process along the way. So strategic accounts have a very disciplined rebalancing process that we exercise so that any time the asset classes get out of balance by 5% or more, we're very disciplined about rebalancing. So for example, as the stock market declines, let's just say that the portfolio was supposed to be half in stocks and half in bonds, they’re obviously more complicated than that, but if that was the simple breakdown. Then in the stock market decline, if stocks got to be 45% of the portfolio, because stocks were falling and bonds were holding steady, as money sort of float into bonds as a safe haven. Then we would sell bonds and buy stocks.
So that is a very disciplined, I was going to say buy low, sell high, but it's a buy a little bit lower, sell a little bit higher type strategy. And we would follow that strategy all the way to the trough of a market decline. So, the strategic portfolios are designed for people who have many years of saving and investing before they're going to rely on the portfolios to provide retirement income.
The advanced and defend portfolios, are built around more of a risk management philosophy. And they're guided by a combination of tactical processes that involve both allocation and security level decisions. The purpose of the advanced and defend process is to protect capital during deep and sustained market decline. So, what you think of when you think of a very typical bear market and a typical bear market lasts a year and a half. It doesn't last a month, the way we just experienced with the most recent decline.
So, using this advanced and defend process takes money out of harm's way and keeps it there during this extended period of the market bottoming process. That's just one of the things that we do. So, we also use, as everyone who's sort of in that mode understands, we have a safety net process that we use. We use, bond ladders to provide a five-year window of protected capital. And clients who are in distribution mode have distribution policy statements that are in place. So, all of those are things that we can use to manage that.
Doug, where are we now with the advanced and defend portfolios in this whole process? And in terms of actual execution.
Doug: Yeah, so as we've mentioned before, we've kind of slowly been adding risk back into the portfolio. Again, you know, trying to do or best to balance out the risks, both the positive and negatives as we talked about earlier.
So, if we want to put a number to it, if a client’s kind of neutral target, was a 60, 40 meaning 60% equity, 40% fixed income. Their current allocation to equities is probably somewhere between 52% and 54%. So, we've got roughly, I'd say anywhere from 6% to 8% cash or defensive capital still yet to deploy in those advance and defend portfolios. We'll kind of continue to take the data as it comes and hopefully if we can continue to grind higher and things start to improve the expectations will eventually get that money back invested.
Mike: Okay. So, another question that came in that sort of is connected to what we were talking about earlier with the elections. Question says, I believe the prospect of the Democrats winning the upcoming election is going to have an immediate negative effect on the market. In light of this, what's the downside of increasing cash positions now while the market is approaching its previous highs? And if the Democrats don't win, we can buy back in, and if they do win, we can buy on the lows.
Do you want to react to that?
Doug: A lot of scenarios to impact there. But I think the thing that we mentioned earlier is, I think it's fair to recognize that markets are, you know, they've run up quite a bit. If we look at it from evaluation standpoint, we can certainly say that there's pockets of the market that are expensive. So, taking risk off the table in that regard, I don't think is a bad strategy, if a client wanted to go that way. Kind of linking it to an outcome that we think we know, but we don't know that we know for sure. I think could be a little bit risky in the sense that right now it seems like the Democrats have a leg up, at least on the poles. But, if the coronavirus situation comes under control, if something happens during one of the debates, I mean, there's still a lot of wild ours here, that could change the current perception of what's going happen. And we certainly don't want to try to front run that, this early.
So, I think it really comes down to trying to make a portfolio decision on a very uncertain outcome. There's still ways to do it that wouldn't be harmful, but we wouldn't want to make a large portfolio decision, based strictly on something like that.
Mike: I would throw in on that. Well, a couple of things, any investor who makes tactical decisions does have to have some opinions and they have to have process. The biggest thing about the process is you can never make a bet that's so big that if you're wrong, it would, you know, bring that mortal spear in.
So, the idea of, and I'm not sure that this was implied in the question even, but that idea of selling out entirely or even selling out substantially, could create the possibility of that mortal spear. We talked about moral hazards earlier. The flip side of the moral hazard is, and of course, what we're talking about there is the fact that the fed has stepped up as a backstop for everything. When we talk about the election as a, sort of the only force that can tug at portfolios, I don't think that's accurate, there are many forces at work. So, if on the same day that we had an announcement, or the day after the election, Democrats sweep, so we've got all these tax things that I mentioned earlier that are working against us. On the same day, we come out and see that three drug companies have vaccines that are approved by the FDA. I certainly don't want to be short the market on that day, because you know, which way is the voting machine going to take that? So, I think we just have to be aware that there are a lot of forces at work.
In other calls, we've talked a lot more about the technical indicators that we build into our process. That's where those indicators start to help because they are good at taking a broad swath of underlying forces. And sort of getting the flow of the market. So, I don't want to overdo this question, but hopefully that adds some color. I would say if somebody looked at that and they had a great deal of conviction, that this was going to be the outcome, then taking some chips off the table would not be a bad idea.
So, we are officially out of time. There's one more question here I wanted to get to, so we're going try and do this in a speed dating fashion. But I think it's relevant for the whole portfolio discussion.
So, the question is, you seem to be keeping a modestly conservative allocation in your advanced and defend portfolio, but how can the market fall if the federal reserve is willing to keep printing money?
Doug: Yeah, I mean, it's almost kind of a cynical way to look at the world. I think in the respect of time. I think the easiest way to answer that question is if we're truly going to cross that bridge, and we've gotten to the point where market downside is going to be curtailed indefinitely into the future because the federal reserve can simply print money and support it. That is a bridge that I don't know that I'm willing to cross over a two month timeframe. This is still the largest economic experiment in the history of the world. And I think before we can claim victory on that and just say, all risk is gone now. I think that's a process that needs to continue to play itself out. Before you can basically just run your entire investment thesis around that.
Now don't get me wrong, we certainly look at that situation and think right now that that's able to drive markets. But if that's going to be the situation going forward, then you're going to see a lot of different things in terms of portfolio construction, things like that. Because rates are going stay low for a long time, the ability to generate income from bonds is going to be very challenged, and clients may need to become comfortable with either, holding more equities, which is naturally going to increase their risk or, reducing their spending. Most people don't want to start at that point. So, I think, you know, I don't know that this is etched in stone yet, but they're certainly doing a good job chiseling it right now.
Mike: And I would add to that, that the thing that makes the fed magic work is a concept that revolves around the velocity of money. So they can print the money, and certainly we've seen stimulus that goes straight into taxpayer's hands or citizens hands, we've seen a bonus in unemployment that goes directly to people. But the normal method for getting money, the sort of federal reserve money, into the system is through the banking system. Where the fed puts the money into banks, banks borrow it from the fed at super cheap rates, then they lend it out to businesses who then deploy it in the economy and then the world goes round and round.
So, when you think about the velocity of money, think about going out to dinner and you tip the waiter. And the waiter takes that tip and Uber's home for the night and pays the Uber driver with that tip. The Uber driver then goes to the gas station and puts gas in his car. Then the guy that drives the gas truck gets paid, and so forth.
And so, money flows through the economy this way and it gets magnified as a result of this. And that magnification is measured by the velocity of money. What's happening now is there's very little demand for this money. So, the fed has put this money out into the system, but banks aren't lending it. You heard Doug mentioned earlier, banks in their announcements are increasing their loan loss reserves, which means they're afraid of bankruptcies.
So, for this relief to work, the system has to complete itself, and in all this stimulus works until it doesn't. And then the voting machine can reverse and begin to feed on itself. So, the simple printing of money doesn't solve the problem, we need to see a pickup in business activity. And when we see the sort of economy reopening that's going on, that's what's allowing the market to sort of look over the horizon and say, there are sunnier days ahead. But if we have a relapse in the disease, which we've seen in a number of the Southern States, or we don't get the vaccines as quickly as we like again, the sort of big money polls are looking for about a two month window, as we mentioned earlier, there are risks out there. And if we just close your eyes and imagine for a moment that this whole COVID event had never occurred, we'd still be looking at a very rich market that was right for a correction.
So, there are risks out there that we still have to be concerned about, especially, primarily managing money for people who are in retirement need to be able to draw money from their portfolios on a regular basis. So, that put some color around that as well.
Okay, we are over our half hour. Thanks for staying with us, everybody. We appreciate your participating in the call. The next call is scheduled for Thursday, August 13th. And as always, of course, if news breaks, we'll be reaching out to you and scheduling something sooner. As always, if you have any questions in the meantime, reach out to us. Either directly Doug or I are here through your advisors, happy to answer anything that comes to mind. Also, if you know anybody that needs help refer them, as we always say, there's no strings to that. We're here to help anybody we can. And that does it for today. Thanks everybody. We'll talk to you soon. Bye bye.