Measuring Risk

July 1, 2020

Mid-year Investment Outlook

We all know that as humans we have a number of tendencies that make decision making difficult. Many of them are coming into play as we collectively try to deal with the uncertainties of the pandemic. For example, "cognitive bias" refers to our tendency to think in certain ways for any problem. This might explain why there are very different sets of opinions on the pandemic that oddly match people's political views. "Anchoring" suggests we rely too heavily on the first thing we hear. The initial claim that face masks offer no benefits has stuck around for longer than makes sense. "Decision fatigue" can set in and then we have a harder time staying the course. When states starting opening up, many seemed all too ready to take a break from hard decisions. And, our difficulty in "measuring risk" is also a big challenge. Now especially since most of us have had no personal experience with pandemics. Lack of experience is not surprising though when considering the fact there have only been serious pandemics in the last 673 years of recorded history. One way to potentially mitigate some of the biases we have in making decisions is to stick to the facts and let them lead us to better conclusions. In trying to tackle the decision as to what is next for the markets, this post will look at the following data: (1) trends in the virus numbers, (2) the stock market's assessment of the economy, (3) key economic data, (4) and the government response to the economic side of the crisis.

(1) Virus Statistics

New cases in the U.S. are increasing again, coinciding with the reopening of many states. We are learning there is no perfect response to a pandemic. The trade-offs between the economic consequences of lockdowns and letting the disease run its course are very difficult.

Even with the rise in cases, there is some good news in that the number of deaths has been decreasing. (All Coronavirus charts from Worldometers)

While Europe seems to be through the worst,

and large parts of Asia were not as affected,

and unfortunately, many emerging countries are still getting much worse.

The effects of the shutdowns around the world were severe enough so it is unlikely any country to find the will to do it again. This may not matter, in the U.S., the pace of new cases appears to be heading up so fast that people and businesses will probably effectively shut down themselves in the near future.

Even in countries that seem to have the virus under control, it does not mean business and lives there are returning to normal.

Japan is currently refusing entry to non-Japanese people who have been to any of over 100 designated countries across the world... Japan Guide
Virus pushes Japanese business sentiment down to lowest level in 11 years...Japan Times

Emerging market countries have a very difficult path ahead with large portions of the population living in close quarters, relatively poor, and lacking enough healthcare. It is hard to conclude that the worst is behind the world in dealing with Coronavirus. The recent optimism is more likely a result of exhaustion with lockdowns and lack of any other good options.

(2) Are Stocks Disconnected with Reality?

With U.S. stock market indices near their pre-virus highs, there is an on-going debate as to why stock prices are so buoyant while the economic picture looks do dire. Digging a little deeper into the data reveals a picture that is not so out of sync.

It is really only big tech that is doing well now, both in profitability and in their stock prices. The 5 biggest tech stocks have swelled in value to account for 20% of the S&P 500 index. Popular indices like the S&P 500 and Dow Jones are calculated using each company's market share (number of shares x price). Therefore the companies valued the most by the stock market have the most influence on the index number.

The outsized effect these tech stocks are having can be seen on the chart below with those 5 stocks (Amazon, Apple, Microsoft, Google, Facebook) compared with a unique index fund (RSP) that weights each of the 500 equally instead. The tech companies are up big this year between 7% and 47% while the equally weighted index ETF is down 14% (thick blue line).

It is the same picture when we look at smaller U.S. companies and around the world - big tech in the U.S. is up while the rest are all down substantially for the year. In the chart below, the Nasdaq index ETF is used to represent big tech (QQQ) which is up 14% for the year. Compare this to small U.S. companies in light blue (IWM), European large companies in red (FEZ), large Japanese ones in purple (EWJ), and emerging markets in green (EEM) which are all down between 6% and 16% for the year.

So upon closer inspection, big tech is doing well but almost all other sectors of the stock markets are struggling just like the economy. But there are some asset classes that have done well this year. These were the ones associated with safety and preservation of capital, namely U.S. Treasury bonds and gold. The chart below compares the same equally weighted index fund for the S&P 500 in blue (RSP) with a physical gold fund in yellow (PHYS) and a U.S. Treasuries bond ETF holding short-term maturities in green (IEI).

(3) Economic Data

Even though there is a great desire to look past the current problems and see life and the economy return to something close to normal, it is hard to find support for that in the economic data. Unemployment claims each week have been declining since the initial shutdown, but are still massive by any measure. Last week the total looking for jobs was still over 1.5 million versus less than 300,000 pre-virus. Economists and investment managers like to anticipate better times ahead by focusing on improving trends in a data series (the rate of change). While it is true the data is getting better, it is still very bad. If Congress does not extend the unemployment benefits and business assistance programs that are due to end soon, the data will likely get much worse again.

Recessions usually take about 6 quarters on average before a recovery takes hold. But economic cycles are normally driven by excess debt and capacity issues. The effects of the pandemic are very different from the norm and the severity of the slowdown shows this. GDP for the US is expected to contract by 8% this year. The IMF recently revised its estimates much lower for the whole world in just one month.

The narrative that the economy will have a "V" shape recovery and be back to a pre-virus state is unfortunately not realistic.

(4) So Much Money

The government's answer has been to throw a lot of money at the problem. This does not solve the medical issues, but it has supported households and some businesses economically while they wait it out.

The Congress has done a great deal and done it very quickly. There is no precedent in post-World War II American history that's even close to what Congress has done. They have passed $3 trillion in stimulus, which is 14% of GDP. It is vastly larger than anything they've ever done. - Fed Chairman Jerome Powell

The amount of money is huge. The chart below shows the jump in government debt versus GDP for major countries around the world. There is a lot more debt everywhere with the U.S. leading the charge with the largest increase. The U.S. is the most indebted major government other than Japan.

Excessively large government debts have historically ended badly given time. What is more worrying is that a large portion of recent borrowing by the U.S. government was purchased by the Federal Reserve with newly printed money. The chart below shows the sharp increase in the money supply as of late.

And there is probably more to come, the Fed has already said they will do whatever it takes to continue this herculean task of supporting the economy by printing even more money if need be.

And the question is, will it be enough? And I don't think we know the answer to that. It may well be that the Fed has to do more. It may be that Congress has to do more. And the reason we've got to do more is to avoid longer run damage to the economy. - Fed Chairman Jerome Powell

To clear up any confusion where this money comes from, the Fed chairman explained it in simple terms on national T.V. a few weeks ago.

We print it digitally. So as a central bank, we have the ability to create money digitally. And we do that by buying Treasury Bills or bonds for other government guaranteed securities. And that actually increases the money supply. - Fed Chairman Jerome Powell

This money will not solve the problems created by the virus, but it will buy some time for households and some businesses. Even so, it is hard to believe that airlines will be back to their former capacity any time soon, restaurants will be full, or even office buildings will be fully utilized for that matter. This means more money printing and debt is likely.

Too much money in the system will debase the value of the currency and sets the stage for asset price inflation. Interestingly, stocks sometimes are inflated too under these conditions but usually with a lot of volatility. The chart below overlays the amount of money in the world monetary system (global liquidity) with stock prices (world financial asset prices). According to history, stock prices should follow liquidity a lot higher at some point.

These periods of currency debasement are normally very bullish precious metals.

Therefore, a larger allocation to gold and gold mining companies and depending less on stocks makes more sense.

Investment Outlook

The biases we humans have in making decisions all come into play when making investment decisions too. Here again, focusing on the data can help keep one on track. In that vein, the data suggest the effects of the Coronavirus will continue to disrupt economic activity for an unknown span of time into the future. The government will likely respond to this with more money printing and borrowing. Therefore, the investments that have done well so far should continue to perform, U.S. short-maturity Treasury bonds and precious metals. There is a high probability of currency debasement that will inflate asset prices more. Stocks may appreciate as well but will probably see a lot of volatility, this will create opportunities to buy quality companies in the US and elsewhere for the long-term. Once growth does start to recover (recent pandemics have hung around for about 2 years), the amount of excess money will probably stoke more traditional inflation, so hedging the potential adverse effects will be crucial.


This blog article nor my advisory entity is not making any recommendations, only pointing out interesting strategies for consideration. Investors should do their own research and consult their advisor before making any investment decisions.

Notaro Wealth Advisory is a registered investment advisor. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. The views and opinions expressed in this blog post are as of the date of the posting, are subject to change based on market and other conditions. This blog contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Please note that nothing in this blog post should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and you should not consider anything to be, investment, accounting, tax or legal advice. If you would like accounting, tax or legal advice, you should consult with your own accountants or attorneys regarding your individual circumstances and needs. No advice may be rendered by Notaro Wealth Advisory unless a client service agreement is in place.