In the world of finance, we have a huge clash right now between the largest economic shock in generations contrasted with the largest ever government response both monetary and fiscal, and that impact between such massive things is causing all sorts of interesting behavior in the markets.
On one hand, we have the biggest global economic contraction of the modern era, the highest unemployment level in post-WW2 American history, and a virus that continues to affect consumer, business, and government behavior. The world went into this crisis with record debt-to-GDP levels, which made what could have been a manageable situation into a more extreme situation. This is an incredibly heavy economic anchor that was built over decades and triggered by a random event.
On the other hand, we have the biggest-ever collective fiscal injection by countries around the world including in the United States, and rapid debt monetization and asset purchases by central banks to facilitate those sovereign deficits and smooth out volatile markets. The Federal Reserve has crossed the Rubicon into buying individual bonds including some junk bonds, as well as muni bonds, in addition to the Treasuries and mortgage-backed securities they already have a long history of buying. This is the ability to use an infinite balance sheet to print money and buy assets.
The result is that we have very large dislocations, like the stock market soaring on heightened liquidity, and junk bond spreads lower than they would be in a natural market, while the economic situation remains stressed.
As this chart shows, employment levels in the United States have crashed to levels not seen since previous recessions in 2003 and 2009, and yet the stock market itself has reflated nearly back to all-time highs.
Now, there are various ways that the above chart could be scaled. But the point is, if someone had told you last year that in 2020, we would have a global pandemic, and a global economic shutdown in response to that pandemic, that resulted in the biggest surge in unemployment in the modern era and the most negative quarter for GDP on record, that the stock market would only fall 30-some percent and then be back near all-time highs in three months?
Probably not, right?
As this next chart shows, the stock market’s rebound and the Fed’s balance sheet rise have been in almost perfect harmony. This lockstep behavior even includes the recent local plateau we have been in since mid-June, as the Fed has tapered liquidity and the market took a step back from its upward trajectory:
The Extent of Economic Damage
While the market enjoyed a nearly V-shaped recovery from late-March to mid-July, the underlying economy is not really showing signs of such a strong comeback. This will take time to work through.
The number of initial jobless claims keep coming down each week, but continued claims are proving to be a bit “stickier”:
Even after this big decline in initial jobless claims per week from almost 7 million at the worst point to under 1.5 million per week lately, they’re still more than twice the weekly peak of the 2008/2009 crisis, which remained below 700k at the worst point.
In other words, 3 months after initial COVID-19 shutdowns, we are still shedding existing jobs faster on a weekly basis than we were at the peak of the Great Recession:
As millions of people continue to lose jobs, millions of other people are getting some of their jobs back or finding new jobs. So, the number of continued claims that has been hovering around 20 million, which is about 3X as high as the level that was reached during the Great Recession, which did not touch even 7 million at its worst point:
As of April and May data, the United States already has much higher unemployment rates than our advanced peers such as Japan, northern Europe, and Australia, and I contend that this divide is likely to continue for quite some time. This is happening for a variety of reasons.
A surface reason is simply that we have different unemployment policies and a greater ease for employers to lay workers off compared to a number of other countries, which can make for a more dynamic economy but can also cause higher peak unemployment levels during crises.
However, perhaps a larger reason is that due to having the global reserve currency for decades in the post-WW2 era, the U.S. has had to run major structural trade deficits decade after decade, and as a consequence of that, has exported a large portion of its industrial capacity to the rest of the world. Economists Robert Triffin and John Maynard Keynes both warned during the Bretton Woods era that the system as constructed would eventually lead to this sort of problem, and they were right in this regard.
In other words, having the global reserve status has created a consistent demand for the U.S. dollar from a global perspective. This is because most commodities are priced in dollars worldwide, and countries need commodities (and have a lot of dollar-denominated debt), and thus need dollars. This keeps the dollar strong and pushes up the import power of Americans and reduces our export competitiveness, so we gradually stopped making things over the years, not just compared to emerging markets but also compared to wealthy peer regions like Japan and northern Europe.
This has left the United States more reliant on the services sector as a share of our economy than most of our peers, and the services sector is disproportionally harmed by COVID-19 and related shutdowns by businesses and governments to slow the spread of the virus. It also means we are reliant on things like masks, pharmaceuticals, and military components from China and similar regions. In other words, it feels good for people in a country to have extra import power, until it hollows out the country’s manufacturing base, which is what has happened.
Most wealthy folks and white collar workers have been insulated from this trend for a while, enjoying many of the benefits of a strong dollar without directly feeling most of the drawbacks, while blue collar workers have generally been more negatively affected, because although their dollars are strong, their jobs have shifted overseas and/or their wages were more pressured downward by foreign competition.
The U.S. has a lower median net worth than a significant portion of our peers despite a higher mean net worth than many of them, which means that we have a greater percentage of people on the brink of insolvency, that can’t afford lost income streams. In addition, the United States has the highest per-capita healthcare costs in the world, and for many people, their health insurance is tied to their employer. Plus, the U.S. went into this crisis with the highest government deficit as a percentage of GDP than most other advanced countries in 2019.
For these reasons, my overall opinion is that the U.S. will be forced to have larger fiscal deficits and central bank balance sheet expansion than many of our advanced peers over the next 3-5 years, even though most nations will also face high deficits and monetization of those deficits. It is a question of relative magnitude relative to GDP.
I will monitor this situation over time to see how it develops.
Equal Weight vs Market Weight
I am watching a few indicators lately, and one of them is the ratio between the S&P 500 equal weight index and the S&P 500 market weight index.
Most major stock market indices are weighted by market capitalization, meaning that the bigger the market capitalization of a stock (the total value of all shares), the bigger its weighting in the index.
For example, Apple Inc (AAPL) has a weighting in the S&P 500 that is more than 100 times as big as Nucor Corporation (NUE), even though they are both S&P 500 members. Nucor is a mid/large cap steel producer, while Apple is one of the largest mega-caps the world has ever seen.
As another example, even compared to other top-100 S&P 500 companies, like Union Pacific Corporation (UNP) or Texas Instruments (TXN), the software titan Microsoft (MSFT) holds a slot in the index that is more than 10X the weighting of either of them.
This market capitalization allocation method is mainly for low costs. Index funds were created decades ago when trading costs were high, and this market-weight momentum strategy maintains minimal turnover. Nowadays, trading costs are way lower, but that is still how many index funds are weighted.
On the other hand, there are some equally weighted indices. An equal weight S&P 500 index, for example, weights each of the 500 companies equally. So, rather than Apple representing over 5% of the index and Nucor representing 0.05% of the index, they would both represent 0.20% of the index. An equal-weight index must rebalance regularly (usually quarterly) to maintain that equal weighting.
Here is how the S&P 500 market-weight-vs-equal-weight data compare from inception of the data in 1989 to the end of June 2020:
However, we can see that there are periods where the market-weight index does way better (such as the 2000 tech bubble), and periods where the equal-weight index does way better (such as the 2007 housing bubble).
Here is a chart that I lighted back in May. The top five stocks in the S&P 500 (Microsoft, Apple, Amazon, Alphabet, and Facebook) now make up over 20% of the 500-company index, which surpasses the amount of concentration that occurred even at the height of the Dotcom bubble:
Historically, the equal weight version tended to go on to perform worse than the market-weight version for the next several years after periods where the top 5 companies had a smaller share of the index, such as the mid-1990’s and the mid-2010’s. Inversely, it tended to outperform significantly from periods where the top 5 stocks had very high concentration, such as the early 1980’s and early 2000’s.
We are currently in the biggest period of concentration in over 40 years.
If we view it as a ratio, meaning we take the S&P 500 equal weight total return index and divide it by the S&P 500 market weight total return index, we can see more clearly periods where one or the other outperforms. Whenever this line is rising, it means equal weight is outperforming, and whenever it is falling, it means market weight is outperforming:
There, a strong pattern appears. During the later stages of a business cycle, and particularly during recessions when the market sells off sharply, investors flock to the biggest and strongest companies, and therefore the market weight version outperforms. On the other hand, during the earlier portions of a new economic cycle, when growth is accelerating, the equal weight version outperforms. At that point, previous market leaders tend to be overvalued, and new leaders spring up to take their place in terms of equity returns.
And then this pattern can be overlaid with the previous point that the equal-version tends to do well over a cycle from a starting point of high-concentration, while the market-version tends to do well over a cycle from a starting point of low-concentration.
If history is of any guide, if a new business cycle begins, we should likely see the equal weight version outperform in the years ahead, after under-performing for the past several years, and particularly under-performing during this crisis. In other words, some of the more troubled names like banks, miners, industrials, and so forth would likely need to rebound more sharply, if there is to be a true broad-based recovery from the March and April lows.
Both the stage of the cycle we are in (mid-recession), and the degree of concentration we have in the S&P 500, would suggest that the next several years are more favorable towards the beaten-down equal-weight version.
On the other hand, investors should always be aware of the possibility of a major structural change, i.e. that “this time is different”. Maybe we’ll enter a new era of mega-cap dominance, where Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Facebook (FB), and Alphabet (GOOGL) continue to outperform, going from over 20% of the 500-company index to over 30%. That is not my overall opinion, but it is an outcome to consider in terms of risk management.
This could depend in part on antitrust decisions for how much acquisition and consolidation that the U.S. government wants to let happen in the corporate sector, which makes it difficult to predict. Alternatively, it could shift in equal-weight’s favor if there is a sustained trend change from disinflation (which disproportionally benefits “growth” names on average) towards reflation or stagflation (which would more likely benefit “value” names on average).
There has been an interesting development in the past couple weeks of multiple major advertisers, from Unilever (UL) to Coca Cola (KO) to Verizon (VZ) to Honda (HMC) to Diageo (DEO), dropping or pausing their Facebook (FB) ad campaigns, and some other social media advertising plans as well. Will it be temporary and blow over, or will analysts need to adjust their bullish forward consensus estimates a bit?
Meanwhile, Alphabet is apparently shifting from secular grower to cyclical mega-cap now that it has such a large market share of the (cyclical) advertising industry, with an anticipated decline in 2020 adjusted EPS, which would be its first adjusted EPS decline as a public stock since the early 2000’s, while it is trading at a more than 32X multiple of analyst-consensus 2020 earnings per share.
Slow-growth blue-chip Apple, at the same time, has been closing stores due to a rise of COVID-19 cases in the United States, and has significant supply chain exposure to China as the economic war between the two great powers continues to heat up, but has been bid-up to rather high valuations.
Long-term Portfolio Updates
I have several investment accounts, and I try to provide updates on my asset allocation and investment selections in each “Economic Research” article.
These investment accounts include a primary passive/indexed retirement account, two actively managed brokerage accounts at TD Ameritrade and Infinity Futures, and the model portfolio account specifically for our Investment Clubs.
Changes since the previous issue:
- Opened a 2% stake new position in Nucor (NUE).
- Added 3% stake in JP Morgan Chase (JPM), now up to 5%.
- Sold 5% stake in Aberdeen Gold Shares ETF (SGOL), now down to 10%.
- Sold 5% stake in Aberdeen Silver Shares ETF (SIVR), now down to 9%.
In other words, I reduced precious metals exposure a bit and increased equity allocation.
This was for a variety of reasons. Precious Metals in my opinion has become overvalued after such a strong rally, it became clear that the stock market was pricing in a V-shaped economic recovery.
I would be happy to shift that 5% stake back into precious metals “if” I start to see the major markets start to roll back over and negative sentiment come back in.
Final Thoughts
The stock market has been bid-up by the combination of fiscal and monetary policy response, while the raw economic indicators remain in a troubled state.
I shifted some equites into precious metals in March (a bit earlier than ideal, rather than right at the bottom), and rode up this rally, but I’ve been putting on the brakes a little bit since mid-July. I am going to keep a close eye to see whether the spring fiscal stimulus is running out of steam or not.
I continue to view assets that do well in an inflationary environment (or negative real interest rate environment) in a positive way for the long run from current levels, as part of a diversified portfolio. This includes certain types of real estate and real businesses, high-quality commodity producers of copper and oil, and quality gold miners.
I also continue to like a diverse batch of global equities as part of a portfolio, but am cautious about the heights that the S&P 500 and Nasdaq have reached in recent months amidst so much fiscal and monetary stimulus, and thus use a counter-cyclical Treasury management policy of taking some chips off the table in overbought conditions, and getting a bit more aggressive in oversold conditions.
Conclusion
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Jason Pries 