By Chris Puplava
Chief Investment Officer, Financial Sense® Wealth Management
June 12, 2020
Despite our asset allocation models arguing for a maximum risk posture in terms of our exposure to stocks, we are overriding our models and staying with a neutral risk exposure. The primary reason for this decision is the incredible amount of uncertainty caused by a global pandemic on a scale not seen in over a century.
No one knows what the full impact of the virus will be on our population and economy, whether we will have a second wave of infections this fall and, if we do, how large will it be and could it lead to another shutdown. Considering this uncertainty, as well as the uncertainty surrounding the upcoming presidential elections, if there is anything we have learned recently, it is to anticipate and be prepared for sudden changes.
This week’s dramatic plunge of more than 1800 points on the Dow is a good reminder of this fact. Volatility works in both directions, although investors have mostly had the wind at their backs the past few months and certainly, more generally, in the years prior to the recent COVID crash.
From our standpoint, in the lead up to this Thursday’s sudden plunge, there were clear signs that the market was becoming overheated and would likely cool off as various measures of investor sentiment were entering frothy territory along with a corresponding surge in online brokerage account openings.
For these reasons, the market decline this week was greatly needed and somewhat expected, though considerably larger than usual, which was surprising. A high degree of speculation combined with a preponderance of algorithmic traders and robots, which often exacerbate market moves, are likely the main contributing factors in this case.
The question we need to answer is whether this week marked a top and whether Thursday’s action was a shot across the bow. While “A” top has formed recently we do not currently believe it is “THE” top since the bottom back in March. We believe this because the economy and labor markets are moving in the right direction as the economy begins to heal from the abrupt stop with the lockdowns, as well the amount of ample liquidity being injected into the financial markets and economy by policy officials.
While many investors have enjoyed the recent run in the markets, sadly there are a great deal of investors who have been observing from the sidelines after raising considerable amounts of cash near the bottom. We have seen an unprecedented dash to cash as money market assets have swelled to nearly $5 trillion, commercial bank deposits have ballooned to nearly $16 trillion, and the Fed’s balance sheet has skyrocketed to over $7 trillion in a matter of months.
Given the large amounts of cash on the sidelines, it is clear that investors have panicked to record levels, even exceeding what we saw during the Great Financial Crisis of 2007-2009. You can see this visually by looking at the figure below showing how money market assets surged over 30% in just six months, the highest rate since the late 1980s. Additionally, commercial bank deposits surged to over 16% growth over the last six months. We have data on commercial bank deposits going back to the early 1970s and we have never witnessed a panic and dash to cash as we saw earlier this year.
Mind you, the trillions of dollars sitting at commercial banks or in money markets is earning a 0% yield as the Fed slashed interest rates this year and the Fed has no plans to raise rates anytime soon. The Fed met this past Wednesday and indicated that interest rates will remain at 0% through 2022. In the post-FOMC meeting press conference, Fed Chairman Powell said the Fed is “not even thinking about thinking about raising rates.” Further, the Fed expects the unemployment rate to remain elevated for years and stated they would purchase $80 billion per month of Treasury securities and $40 billion of agency mortgage-backed-securities (MBS) per month.
The investors who panicked as the market sold off have stayed on the sidelines as we’ve yet to see money market assets and commercial bank deposits decline. Should the market decline further we believe the capital that flew into cash would welcome lower prices to get back in as you simply cannot retire nor live on 0% interest rates indefinitely.
While we believe volatility is here to stay, to filter out the daily noise of the market’s wild action we have developed a baseline for the market’s path by comparing the S&P 500’s current trajectory relative to other bull markets and used the 50% retracement mark (when half of the prior bear market’s decline has been recouped) as the reference point. We highlighted the chart below in our last client letter and will provide periodic updates on it.
The average path of the prior bull markets that began after WW II is shown below with the dotted black line, the best-case scenario is shown by the green line and the worst-case scenario is shown by the red line. From early April to late May, we were following the average path of those prior bull markets very closely but then, as the market jumped, we moved to even exceed the best-case scenario recently. Even if the S&P 500 fell 100 points more it would only take it to the average path of prior bull markets, and we would have to see it fall below 2600 to be outside of the historical norm.
As we stated at the opening of this letter, we are overriding our model’s call for maximum risk in light of elevated uncertainty surrounding the COVID-19 pandemic as well as the upcoming presidential elections. We will continue to monitor both situations to determine whether we should increase or decrease our risk exposure. The current environment is highly fluid and we will continually update clients on our thoughts to keep you informed.
If you have any questions regarding your specific accounts or our investment strategy, please do not hesitate to reach out to our advisory and investment team.
Chief Investment Officer
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