Monthly Market Muhsings - May 2020

Markus Muhs - Jun 02, 2020
The Markets are up AGAIN?
Monthly market update
Kind of the first thing that comes to mind almost every morning when I log in to my work computer (from home, of course) and see the futures trending upward again. What’s causing it?
I mean, on the one hand, we did have a rapid decline from all-time highs in February to March, and obviously still have a ways to go to regain those highs on the TSX, S&P 500, and most world market indices. Some recoil from those lows is to be expected. But we have absolutely no business being so close to those previous highs; at least not at this time. Those highs were reached at a time when the markets were relieved that (apparently) China and other early-infected countries got their coronavirus issues under control and we hadn’t heard much out of Italy or the rest of Europe yet. That was a time before full lockdowns around the world, negative GDP growth, and double-digit unemployment.
The thing is, it was also a time before trillions upon trillions of dollars of quantitative easing, not just from the U.S. Fed, but from central banks around the world. Brrrrrrr as the internet meme goes. In January/February I think most strategists were reducing their predictions for rate cuts to maybe 1 before year end. Instead, the Fed lowered their overnight rate all the way to 0-0.25%... on a Sunday!
Alongside this monetary policy comes unprecedented fiscal policy. I remember back in 2008, when fiscal stimulus and bailout bills, like TARP, bounced around in Congress for a week or two at a time, and the whole fiscal stimulus process, along with monetary easing, took place over a period of more than half a year (fall 2008 to spring 2009, mostly). This time it all happened inside of a week in March.
What I think we’re seeing in the markets is plain old demand-side inflation. We may be a long ways off from seeing significant inflation in actual consumer price indices (that would take either a significantly stronger economy or systemic supply issues driving up costs), but since much of central bank actions involve purchasing of financial securities—traditionally government bonds, but increasingly other fixed income—that’s where all the newly “printed” money first flows to and that’s what’s being inflated.
A primer on how central banks effectively “print” money: they can’t just literally do what Powell is doing in the above tweet. What they do is they purchase securities (again, mostly government bonds) from the open market, to be held on their balance sheet until the day comes that they might want to tighten the monetary supply, at which point they sell these securities back into the market and take that money back out of circulation. Effectively, a lot of “printed” money does find its way into consumer hands, especially in this case with governments around the world spending trillions on stimulus and subsidizing incomes for the temporarily unemployed. That spending (I think the U.S. is pacing for a 3 or 4 trillion dollar deficit, while Canada is pacing a quarter trillion, but I lost count) is financed largely through central banks buying that newly issued debt.
An equal to larger portion of the new money supply is going right into buying bonds from the open market though and that, I believe, is leading to marked inflation of all securities, including stocks. It should also be noted that when demand for bonds is high it pushes up their prices (just like stocks), effectively lowering their yields to maturity and that is how we end up with lower and lower rates on our savings accounts, GICs, loans, mortgages, and bonds.
Don’t forget there’s still a huge amount of money in pension plans and people’s individual retirement plans out there, probably more than ever before in real terms. A bubble generation of “boomers” is in or close to retirement, with a large portion of their accumulated wealth invested in things, and another bubble generation of “millennials” is in or entering their 30s now and saving more than ever before. A lot of money is looking for a home; it wants to be invested in something, anything, regardless of what the economy’s doing. 
If central banks are competing to purchase securities too, that just leads to evermore inflation in security values. If the Fed buys government bonds from a fund manager, that fund manager then has cash they need to invest into something else. Certain proportions of pension funds need to be in bonds and many personal investors want to have some bonds in their portfolios too. For that reason, bonds at near-0 (or even negative) interest rates are still being purchased. Boeing, a company that’s faced all sorts of tribulations over the past year and a half, had absolutely no problem raising $25 billion cash to help them stay afloat. Recently Amazon (a risky tech company, right?) sold 3 year bonds at barely a smidge higher interest rate than what the U.S. government can issue them for.
As is intended, when central banks buy securities, money is flowing up the risk curve into riskier assets, like stocks, whether it’s pension plans pushing more into stocks because they’re unable to maintain their long term defined benefits via 0.5% bond yields, or individuals seeking higher yielding stocks (currently the average dividend yield of the S&P500 is 3-4 times that of the 10 year treasury bond, something that hasn’t happened since the early 1940s). So there’s a lot of money looking to be in stocks too.
This inflation, caused by a lot of money seeking out scarce securities is why today the markets are really not that far off their highs. Can they fall during a bad news backdrop, like this fabled “second wave” or COVID19 the noisemedia threatens us with? Probably and likely. That money though can only temporarily flow out of stocks, as it did in February/March and there aren’t really a lot of attractive alternatives for it to go into, with money market yields near zero and bonds, again, very unattractively priced (at massive historic overvaluations, if you ask me).
So, as each day passes, for the time being at least the path of least resistance for stocks is up.

What I’m doing

I recently did a bit of rebalancing in my discretionary portfolios, reducing the equity allocation somewhat. This isn’t a tactical bet against stocks, but rather a relieving of the tactical move in favor of stocks that I made in March. Before you think I’m some genius who timed the market bottom perfectly, let me admit that I’m not, and I did in fact up the equity allocation during the first two weeks of March—TOO EARLY—and then missed an opportunity to up it even more (at least getting my balanced portfolio from 65% stocks to 70%, as I had intended to do) in late March before a rapid recovery in the markets. With market sentiment now having returned to modestly bullish I decided to scale this back just a bit, if for no other reason than to have a bit of cash on hand if any other opportunities come up. 
Equity allocation was mostly subtracted from large cap U.S., the best performing part of the portfolios, and in the process I also rebalanced the non-Canadian component of the portfolio to 50/50 U.S./International. The Canadian equity sleeve was also rebalanced to 10% of each portfolio.
I’ve been using a couple of actively managed international equity funds in the portfolio, alongside a popular developed market index ETF. Both active funds handily beat the index over the past year, and with their MERs being among the lowest of all active international equity funds out there—not that much higher than the index ETF—I decided to also tilt a little bit out of index in the international sleeve and up the allocations to the active funds.  

Markus Muhs, CFP, CIM