Providing succinct, entertaining and savvy thinking on global capital markets. Our goal is to provide discerning investors the most essential information and commentary to stay in tune with what's happening in the markets, while providing unique perspectives on essential financial issues. And just as important, Fisher Investments MarketMinder aims to help investors discern between useful information and potentially misleading hype.
As stocks continue their jagged recovery from March 23’s low, a second COVID wave isn’t the only worry on investors’ minds. For weeks, pundits have warned a second shoe waiting to drop lurks on bank balance sheets, in the form of collateralized loan obligations (CLOs)—securitized corporate debt. In the wake of some high-profile bankruptcies—and with analysts presuming many more will follow—pundits draw parallels between CLOs and their mortgage-backed cousins, collateralized debt obligations (CDOs), the securities widely seen as responsible for 2008’s financial crisis. If corporate debt goes the way of the housing market, people fear bank balance sheets will be collateral damage, triggering a 2008 repeat. But as we will discuss, there are quite a few reasons this scenario is unlikely.
For one, lost in most coverage is the simple fact that US banks’ exposure to CLOs is tiny. At 2019’s end, S&P Global’s analysis of Federal Reserve data put banks’ holdings of CLOs at just under $100 billion—a sliver of the $17.8 trillion in total bank assets at that time.[i] Of that, around $30.2 billion is designated as “held to maturity,” while roughly $69.3 billion is marked for sale. This is crucial since accounting rules have changed since the financial crisis. Back then, banks had to value all assets at market price or “fair value,” regardless of whether they intended to sell them. This created problems for rarely traded, hard-to-value assets like CDOs. When hedge funds sold CDOs at fire-sale prices, banks had to mark down the value of all comparable assets accordingly. This rule created the vicious cycle of fire sales and writedowns that wrecked bank balance sheets and forced several major financial institutions out of business. Eventually, at the prompting of formed FDIC chief William Isaac and others, regulators recognized the error of forcing mark-to-market accounting on illiquid assets banks never intended to sell. So in mid-March 2009, they suspended the rule—and revised it months later. Now, when these securities hit rough patches, banks need only mark those designated “for sale” to the most recent sale price. For those marked “held to maturity,” banks can disclose the market value in a footnote and carry on. That further defangs the already very small risk CLOs pose.
Worries about CLO credit quality also seem overstated. In general, CLOs largely echo high-yield corporate bond markets, which usually do quite well early in a recovery—even as bankruptcies mount. That was the case in 2009, and all signs point to a repeat now. US high yield bond interest rates peaked at 11.4% on March 23, the date stocks bottomed.[ii] Friday, they closed at 6.68%, not far removed from their pre-bear levels.[iii] Bond markets are forward-looking, just like stocks. If credit risk were off the charts, yields probably wouldn’t have nearly halved in just three months.
As many seek explanations for stocks’ rise since March 23, we think it is worth highlighting one factor virtually no one will likely land on: corporate share buybacks. These have cratered lately as companies—many of them shuttered by COVID lockdowns—tightened their belts in response to shrinking revenues. In our view, this undercuts the recurring claim during the last bull market that buybacks were the only force driving stocks higher—and should call into question theories arguing any single factor underpins demand.
Many, many firms are seeking myriad ways to bolster their balance sheets and add liquidity. Early on, there were plentiful reports that smaller firms were seeking to tap credit lines simply to increase cash on hand. Now it seems many small firms are issuing new shares via secondary offerings to raise liquidity. Hence, it is perhaps unsurprising that buybacks have tanked. We see this as a sensible move in many ways—one that should help firms meet near-term financial needs and provide something of a safeguard if financial pressure persists. Beyond businesses’ voluntarily dialing back repurchases, any company drawing on CARES Act relief funds is legally barred from buying back shares until a year after it repays the loan. This confluence of factors has driven over one-third of S&P 500 companies to suspend buyback programs since the crisis erupted.[i] On Tuesday, Bank of America noted year to date buybacks among their corporate clients—which have directionally tracked S&P 500 company buybacks since 2010—are 43% lower than this same time last year.[ii]
Yet buybacks’ absence doesn’t seem to have hindered US stocks much. The S&P 500 has surged 39.7% off March 23’s low, albeit with occasional volatility.[iii] Considering efficient markets rapidly incorporate widely known information—and buyback plans are publicly announced—any negative impact from cutting share repurchase plans should already be reflected.
More generally, we see markets’ rise as powerful evidence against the oft-heard claim that buybacks were the only source of stock demand at various points in the 2009 – 2020 bull market. Consider this smattering of headlines:
As the S&P 500 hit breakeven for the year last week, nearing its February peak, we heard—and still hear—a common refrain: The rally isn’t real since most US stocks remain negative on the year. Without mass participation, it is a mirage in which only Tech and coronavirus winners are up. One analysis in The Wall Street Journal, which centered on the Wilshire 5000 (an index including every publicly traded US company), observed that 73% of companies still had negative year-to-date returns as June dawned. Many other studies have made similar observations, using year-to-date data. Just one problem: Looking only at year-to-date returns invites skew from companies that underperformed at the end of the last bull market or got hammered hard in the bear. If you look only at the rally since March 23, it becomes clear participation is quite broad—a typical trait of new bull markets.
For our analysis, we used constituent data from the MSCI USA Investable Market Index—not as broad as the Wilshire, but it still covers 99% of total US market capitalization. As of Wednesday’s close, 2,274 of the index’s 2,346 constituents that have traded since March 23 are up.[i] That, to spare you the math, is 96.9% of American companies. A little more than half are beating the index’s 41.2% return over this span—in other words, it isn’t like Tech and coronavirus winners are up gangbusters while everyone else is up 1%.[ii]
The sector breakdown is also largely consistent with what we would expect to see in an actual recovery. Positivity is fairly uniform, with Consumer Staples having the low share of positive constituents (92.3%) and Tech the most (99.4%).[iii] But the traditionally defensive sectors, for the most part, have fewer outperformers than the others. Only 13.6% of Utilities companies and 27.2% of Consumer Staples firms are beating the index—the latter countering the popular notion of long lines at grocery stores creating many stock market winners.[iv] That narrative, widely known by the time the recovery began, likely ran out of steam some time ago. Elsewhere, it may seem surprising that only 42.2% of Communication Services companies are outperforming, given that sector is home to some Tech-like companies in its Internet Media industry.[v] But Communication Services also includes Telecom, which is traditionally defensive like Utilities. Meanwhile, Energy has the greatest concentration of outperformers, with 80.9% ahead of the index, a logical outcome of Energy stocks getting whacked hard as oil prices plunged earlier in the year.
Whenever a major news item affecting lots of people breaks, one thing is almost sure to follow: scams. Wrongdoers often see crises as opportunities—chances to prey on society’s high emotional pitch. COVID-19 is no exception. Back in April, we pointed out some then-common ploys. But now, with time and the crisis’s continued evolution, more are emerging. According to Federal Trade Commission (FTC) data, nefarious activity is fairly widespread, with almost 92,000 reported cases as of June 11, which the FTC estimates have cost Americans almost $60 million. Here is a quick rundown of the new methods criminals seem to be employing to help you stay attuned—and on guard.
Phony Contact Tracing
In what seems mostly like a twist on the old IRS scam (which itself was a twist on the Social Security fraud, and so on), it seems some wrongdoers are now trying to capitalize on contact tracing. Our guess is they see opportunity in this given three convenient factors for them: Contact tracing methods aren’t well known by the public; by definition, contact tracers must reach out on an unsolicited basis to individuals they suspect have had contact with someone suffering from COVID; and, finally, getting a call from a contact tracer would likely raise fear among the recipients.
Has America’s economic recovery begun? The US released retail sales and industrial production on Wednesday, and both rose for the first time since most of the country went into an institutionally induced coma in hopes of slowing COVID-19’s spread. Retail sales jumped a record-high 17.7% m/m, triggering oohs and ahhs from analysts.[i] Industrial production met far less fanfare after it rose just 1.4% m/m.[ii] We wouldn’t read much into the sizable difference in growth rates, as lockdowns hit retailers and heavy industry differently. Rather, each report offers some clues as to how the US economy is responding as states and counties begin reopening.
Exhibit 1 shows industrial production year to date. As you will see, May’s rise doesn’t come close to erasing the lockdown-driven declines. Total output remains 15.4% below its year-to-date high in February.[iii] But the headline number is a bit deceiving, as falling utilities and mining (mostly oil drilling) production skewed it downward. For utilities, this is unsurprising. Mild spring weather likely conspired with lingering business closures to sap demand for electricity. For mining, it is equally non-shocking, as the -6.8% m/m drop comes as producers likely continued responding to very low oil prices.[iv] As for manufacturing, the largest subset of industrial activity, it enjoyed a stronger rebound, at 3.8% m/m. But, like the headline number, since it crashed harder overall during the lockdowns, factory output was still -17.0% below February’s year-to-date high.[v]
Exhibit 1: Industrial Production and Selected Components, Year to Date
The S&P 500 fell -5.9% Thursday, its biggest one-day drop since March 16, apparently sparked by reports hinting at an emerging second wave of COVID-19 in select US states.[i] This will no doubt further stoke widely held fears of the virus returning, renewing lockdowns and thereby causing markets to retest their late-March lows—or worse. But we think this is a time to remember that no market recovery moves in a straight line. Further, we think it is premature to suggest a second wave packing sufficient negative surprise to drive stocks materially lower for long is at hand.
In recent days, several states have reported increasing infection rates and hospitalizations, seemingly stoking this week’s volatility. For example, new daily cases in Texas and Arizona on Wednesday hit their highest level since the pandemic started. Oregon—which has largely avoided major COVID outbreaks—saw its highest reported new case totals on Thursday and paused its reopening for a week, forestalling plans set to take effect Friday morning. Hospitalizations also jumped in all three states, implying increased testing isn’t the only reason for rising caseloads. Several other states saw the percentage of positive tests climb. In Texas, Houston city officials said they may have to re-impose a lockdown, at least to some degree. It seems likely this news, which echoes fears existing throughout this crisis, drove Thursday’s sharp drop. But we think the market’s reaction looks mostly sentiment-driven. Whether a new wave packs more punch and renews or extends lockdowns beyond what investors presently anticipate remains to be seen. No one possesses any unique knowledge on this front now.
Market volatility—even extreme volatility—doesn’t tell you much on its own. Recoveries never move in straight lines. Such short-term swings aren’t predictable—nor do they predict market direction. As we documented Wednesday, there was considerable uncertainty coming out of the last bear market in 2009. While there was a sharp recovery off the March 9 trough then, it stalled in mid-June, not unlike 2020. From June 12 to July 10, 2009, the S&P 500 fell -7.1%.[ii] In a familiar refrain, headlines warned stocks had climbed “too far, too fast” amid ongoing economic contraction and the advent of swine flu. Yet this weakness proved to be a countertrend headfake. Stocks resumed climbing in what turned out to be the early days of history’s longest bull market. In the aftermath of 1990’s bear market, stocks’ rally faced a brief interruption by a -5.6% slide from December 21, 1990 – January 14, 1991 as tensions between the US-led coalition and Iraq reached fever pitch.[iii] Despite war’s commencing days later, stocks rebounded and kept climbing. To be sure, there are times like the October 2002 – March 2003 stretch when markets retested October’s lows. That could happen now. It also remains possible that stocks head lower than March 23. Yet both of those scenarios are quite far removed from where markets stand today. The key factor, in our view, is how reality lines up with expectations. Markets have been anticipating a second wave for months, which raises the question of whether the scenario we see now is likely to prove worse than what investors’ fears have already factored into stock pricing.
With the S&P 500 up 43% from its March 23 year-to-date low and closing in on its prior peak, one theme seems to be dominating financial commentary this week: the apparent disconnect between soaring stocks and plunging economic data.[i] Some of it struck us as rational, pointing out that it is normal for stocks to appear cold in the face of civil unrest and improve before the economy does. But the vast majority of it presumed the market must be incorrect, driven by too-high hopes and Fed policy, with a reversion in store once investors come to grips with just how bad things are. We acknowledge the possibility, but we also think it is worth pointing out that this is how bull markets normally begin. Stocks are a leading indicator. They move on the gap between expectations and reality over the next 3 – 30 months or so, not the next 3 – 30 days. To show this, we thought it would help to take a trip down memory lane to see what things looked like in the weeks and months after March 9, 2009, the day the last bear market reached its ultimate low and a new bull market began.
Let us start with the headlines, which looked an awful lot like they do today. Here is just a smattering, starting with one of the biggest stories on the day stocks bottomed out:
Has Europe’s time to shine arrived? Eurozone stocks are up 47.0% since their March 18 low.[i] As is the case stateside, many credit European policymakers for powering the rebound. In our view, this is a misperception. We think countries’ reopenings matter more, and the latest data out of Europe reveal promising economic green shoots—signs of what we think stocks have been anticipating over the past two months.
When the COVID crisis went global, European policymakers implemented similar measures to their developed world counterparts: The ECB ramped up its quantitative easing (QE) program, and national governments announced fiscal measures to aid afflicted industries. Yet some commented these plans trailed America’s in size and scope, which included Congress’s CARES Act and a multitude of “extraordinary” Fed measures. In recent weeks, the Europeans have seemingly bolstered their efforts. The EU’s 2021 – 2027 budget proposes €750 billion in coronavirus relief, funded in part by newly issued common EU “coronavirus” bonds and serviced by direct Brussels taxation. The ECB increased its QE program by €600 billion, bringing the total to €1.35 trillion. Even Germany, which many consider a bastion of fiscal discipline, announced a €130 billion spending package. Headlines cheered the plans, with many pundits seeing them as essential to a recovery.
We agree these announcements may have positively surprised investors, buoying short-term sentiment. Many likely didn’t anticipate the breadth of Germany’s spending plan given the country’s frugal reputation. Save for the 2008 – 2009 global financial crisis, Germany has resisted calls for stimulus spending over the past 30 years—even during the eurozone’s 2011 – 2013 recession. Similarly, past proposals for collective EU or eurozone debt have stirred excitement—only to have politics sap the momentum.
After the steep rally from March 23’s lows, many major indexes finished Monday a hair removed from pre-bear market highs: The MSCI World Index is down -5.3% and the S&P 500 is down just -3.9%.[i] The NASDAQ? Up 1.4%.[ii] If the S&P 500’s gains continue, it would rank among its quickest recoveries in history. However, just because the stock market has mostly climbed back from panicky bear market lows doesn’t mean behavioral risks aren’t present. They just change. As markets near pre-bear market levels, many investors experience an urge to sell, fearing a renewed drop. We call this, “breakevenitis” and in our view, it is a counterproductive urge. No one bought stocks with the objective of going through a frightening downturn and holding to breakeven. Times like this are a call to refocus on your long-term goals and needs—not what stocks have just done.
Hitting a breakeven point—and getting out—may seem to provide relief. To many, seeing their portfolio values fall sharply in a bear market or correction leads them to want to step off the proverbial rollercoaster. Many who suffer breakevenitis correctly and commendably held on when stocks were in the bear market’s throes. But now, with stocks nearing pre-bear market highs, they don’t want to “risk” a recurrence. Given markets’ rally, they rationalize, it isn’t like selling locks in losses. Acting on this urge may provide you with emotional relief, but that short-term perceived benefit can bring tough long-term consequences. What if that second shoe never drops and you miss a good chunk of bull market returns? If you think of “risk” not from the standpoint of enduring short-term declines, but rather, failing to achieve your longer-term financial goals, there is every chance selling at breakeven could increase your personal risk, no matter how good it feels in the moment.
Generally, people own stocks for long-term growth, whether to avoid depleting savings in retirement or for some other, larger purpose requiring market-like returns over time. That often means you need growth over your entire investment time horizon—the length of time money must be invested to reach your financial goals. This could be decades. Given medical advances, lifespans are lengthening. A healthy 60-year old today has a high (and rising) likelihood of hitting 90. America’s fastest growing demographic is 100-year olds. The S&P 500, the stock index with the longest reliable dataset, has averaged 10.8% annualized total returns since 1925, a figure that includes all historical bear markets.[iii] Achieving stocks’ high long-term returns, though, generally means participating in bull markets—especially early bull markets, as these gains compound later.
Beyond the obvious takeaway from recent economic data—that economic conditions are generally dismal, if getting less so lately—some recent releases have included interesting curiosities we think are worth noting. While none have make-or-break implications for investors, they all illustrate some of the highly unusual aspects of the economic stretch we are enduring.
The first appears in US purchasing managers’ indexes (PMIs)—surveys seeking to gauge the breadth of economic expansion or contraction, with 50 dividing the two. Thanks to a calculation quirk, IHS Markit’s May composite PMI of 37.0 was below the manufacturing and services PMIs (39.8 and 37.5, respectively) that ostensibly comprise it.[i] The oddity—which initially appeared in May’s flash (or preliminary) PMIs—stems from the composite gauge using a subindex of manufacturing production, which has a mere 25% weighting in the headline manufacturing index. The number of firms reporting output growth in May dropped precipitously. As May’s report states, “The impact of ongoing emergency public health measures following the escalation of the COVID-19 outbreak led to a further severe decline in production across the U.S. goods-producing sector in May. … With the exception of April's recent nadir, the rate of contraction was the fastest since February 2009.”[ii]
So, what drove up the headline reading? In the report, Markit’s economists hinted supplier delivery times were extremely long. Normally, this would be a sign of strong demand. Not so now, when it is more about interruptions to business and the supply chain. The Institute for Supply Management’s (ISM) May PMIs—which survey fewer firms but have a longer history than Markit’s—echo the point. While ISM’s headline May manufacturing gauge rose to a still-contractionary 43.1 (from April’s 41.5), the Supplier Deliveries Index registered 68.0.[iii] Likewise, ISM’s May non-manufacturing Supplier Deliveries Index notched 67.0.[iv] Notably, though, ISM’s manufacturing supplier deliveries index fell 8.0 points from April, while non-manufacturing supplier deliveries dropped a whopping 11.3 points.[v] These indicate looser restrictions are helping businesses repair supply chains—a positive sign, even if it curiously detracts from headline PMI readings.