Cliff Hodge, CFA
Chief Investment Officer
October 13, 2020
“Two roads diverged in a yellow wood, and sorry I could not travel both, and be one traveler…”
In our view markets are at an important crossroads which will have a significant impact on returns into year end. Additional fiscal stimulus is at the crux. In a positive outcome where a large $1.5-2T stimulus bill gets passed, and we avoid a contested election we could see another 8-10% of upside before year end, compared to 10-15% downside in a negative outcome. Rather than risk our clients hard-earned capital betting heavily on one outcome versus the other, we’re choosing to take a somewhat more conservative approach, and split the difference. What this means for portfolios is that on the one hand, we have allocations toward higher growth investments paired alongside defensive positioning and a bit of cash on the equity side. We should outperform our benchmarks in a risk-off scenario, but will likely lag in a risk-on scenario shorter term (going into year-end). Given the current environment, we are ok with this trade-off. Markets remain over-valued on nearly every valuation metric we track from a fundamental perspective, so we would welcome a pullback to more normalized levels which present a buying opportunity in anticipation of a cyclical rally in 2021.
As a natural contrarian my first inclination often is to follow Mr. Frost’s advice and seek to take the road less traveled. While this bias can be helpful in investing, being contrarian only for contrarian’s sake can be just as bad as always blindly following the herd; both leading to poor investment results. Widely-followed billionaire investor Howard Marks of Oaktree, wrote in one of his famous memos earlier this year that, “One of the biggest mistakes an investor can make is ignoring or denying his or her biases.” One way we combat our internal biases at Cornerstone is via scenario analysis. Gaming out various paths that markets and the economy may take and assessing their likelihood can help us remain objective. In conducting these exercises there are times when the stars align; incoming data and intermarket relationships illuminate the path forward. Other times, like where we are today, in the midst of a global pandemic, weeks away from an extremely divisive election, with markets disconnected from economic reality, the overwhelming uncertainty renders facts and historical precedents (because there are none) inadequate. One thing is certain. With the S&P 500 trading at 37x trailing Price to Earnings (P/E) multiple, 26x 2021 earnings estimates, and an unprecedented (there’s that word again) 181x Total Stock Market Cap to GDP (Buffett Indicator), there is no question that short-term risks are elevated.
In our view markets are at an important crossroads which will have a significant impact on returns into year end. Additional fiscal stimulus is at the crux. While the eventual resolution, will become clear between now and once the election is settled, the divergent paths that the market may take may likely result in 1 of 2 extreme outcomes. In a positive outcome where a large $1.5-2T stimulus bill gets passed, and we avoid a contested election we could see another 8-10% of upside before year end, compared to 10-15% downside or more in a negative outcome. Given the unusually wide chasm between the optimistic and pessimistic cases at this time, rather than risk our clients hard-earned capital betting heavily on one outcome versus the other, we’re choosing to take a somewhat more conservative approach, and to split the difference. Of course, this means that, by definition, we cannot be 100% correct, and we acknowledge that the market has a way of making fools of those who think they can outsmart it. Given the current environment, we are ok with this trade-off.
Why this stance? One look at Wall Street year-end targets for the S&P 500, as of the writing the median forecast per FactSet is 3780, more than 10% from current levels, shows that consensus is firmly on the other side. As always, we rely on our process which is powered by data and intermarket relationships. From an economic perspective, we have seen momentum slow in more than a few of the metrics we track including, the labor markets, income and spending data, and industrial production as the boost from the initial Cares Act dissipates. While the headline unemployment rate came down to 7.9% in the most recent September report, below the surface the data was more worrisome. The headline number fell mostly due to the unemployed leaving the labor force as the participation rate fell. Not only is employment growth slowing, but a significant number of previously categorized temporary layoffs have now been reclassified as permanent. This trend has increased in 6 of the last 7 months. We may in fact have to live with the economic consequences of a weak labor market, longer than we may be living with COVID.
When viewing the markets, recent strength in the U.S. dollar against other foreign currencies, coupled with sharp declines in oil, weakness in copper, lumber and other cyclical commodities has increased the probability of a risk-off event (QUAD 4) in the 4th quarter. Recent outperformance in Utilities and low volatility stocks alongside our volatility signal in the VIX, also referred to as the “Fear index” remaining stubbornly elevated corroborates the view. The setup is eerily similar to what we witnessed in late August before the September swoon. Prudence takes precedence when our signals flash warning signs.
What this means for portfolios is that on the one hand, we have allocations toward higher growth investments paired alongside defensive positioning and a bit of cash on the equity side. We should outperform our benchmarks in a risk-off scenario but will likely lag in a risk-on environment shorter term (going into year-end). Markets remain over-valued on nearly every valuation metric we track from a fundamental perspective, so we would welcome a pullback to more normalized levels which in our view present a buying opportunity.
From an intermediate and longer-term perspective, we are constructive on equity markets and risk in general, as our models are picking up an inflection higher year over year in GDP growth in 2Q21. In our parlance, the forecast for 1H2021 is for consecutive quarters of Quad 2, where growth and inflation accelerate. This economic regime is positive for risk assets and could catalyze the long-awaited rotation into Value. Regardless of the outcome of the election, the Fed will continue extremely easy monetary policy, and we anticipate further fiscal support, which could be magnified in a Democratic Presidency. We have been putting our “shopping list” together and stand ready to pivot toward more cyclical and value-oriented positions should the positive scenario win out over the coming weeks or if/when a further pullback materializes.
We thank you again for the opportunity to come and work for you every day. I’m happy to share that the Cornerstone family has expanded! (in more ways than one). Sean Bandazian, whom you will get to meet soon hopefully, joined us in May as an Investment Analyst and brings over a decade of experience in trading and investing analysis. He has already proven to be a great addition to the team. On a personal note, my wife Lindsey recently gave birth to our first daughter, Addison Rose Hodge, (Addy Rose) who joins her brothers Finn and Jack to round out the Hodge clan!
2020 has been an unforgettable year in so many ways! We look forward to many more years of continued growth of our families, our relationships and our clients’ portfolios.
Cliff Hodge and Team Cornerstone
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This material provided by Cornerstone Wealth Group is for informational purposes only. It is not intended to serve as personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment. Any securities mentioned herein are not to be taken as advice or recommendation to buy or sell a specific security. The information provided may not be applicable to your account managed by Cornerstone Wealth Group. Please contact Cornerstone Wealth Group for specific information regarding the holdings and trading activity of your account. Opinions expressed in this commentary do not represent a personalized recommendation of a particular investment strategy to you. Additionally, you should review and consider any recent market news. All expressions of opinion are subject to change without notice in reaction to shifting market or other conditions. Data provided is believed to be accurate, but its accuracy, completeness or reliability cannot be guaranteed.
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