Dear Clients and Friends of Insight,
It has been said that good decisions come from keeping it simple. We agree. This skill helps provide a clear vision of the landscape ahead and is crucial to long-term investment success. To simplify what is complex, we focus on the most essential factors. Then, we distill potential outcomes and form conclusions that support our purposeful decisions. This ability is especially important in today’s complicated and foggy world. Let us get started.
What about our economy? It is currently dreadful. Everyone agrees, so that does not matter. What does matter is the future path of our recovery. About that, there is wide disagreement. To simplify, macro-economists and strategists rely on broad data in their “models” to make forecasts of future economic activity. Micro-economists and strategists look well beneath these numbers. They analyze the underlying decisions and motivations of the economy’s individual participants to guide their forecasts. Investors who focus on macro analyses, almost entirely, have a gloomy outlook for the economy and hence are bearish about stocks. Investors focused on micro analyses tend to have a more positive view of the strength and duration of our recovery. They are more bullish. Today’s unpredictable and contradictory swings in reported data make these analyses difficult and their conclusions less reliable. That said, we favor the assessments founded from a micro view and believe our economy is resilient and has an underlying strength to it.
How did the stock market roar back so strongly while revenues and profits are still shrinking for so many businesses? Simply put, investors feel more certain about the future now than they did during the midst of the crisis. Recall the key issues then. Global economies had already begun slowing and investors were worried about an upcoming global recession. Energy markets were in disarray and the price of oil was collapsing. We knew very little about the coronavirus, and the potential for a severe health care crisis was emerging. Now the recession has arrived, followed quickly by unprecedented global fiscal and monetary responses. This stimulus should pave the way for the world’s economies to eventually resume their growth, benefiting revenues and profits. Oil markets have now stabilized as supply and demand have come back into balance. This virus is less of a mystery today, and tools to combat Covid-19 are being developed quickly. Remember, stocks are a leading indicator.
Why might the stock market advance further, given how far it has already advanced? Based on a variety of measures, stock prices are high, but valuation levels tell only part of the story. Let’s look at the simple supply and demand situation. The number of companies and shares listed on U.S. stock markets has been declining for years. This trend of shrinking supply is likely to continue.
Meanwhile, the demand for U.S. stock ownership continues to grow. Buyers include pension and retirement plans, insurance companies, endowments and foundations, sovereign governments, corporations, private partnerships, and individuals from all across the globe. They are awash in cash and their demand for stock is likely to continue growing.
What is more important here is that the returns investors earn from bonds and cash pale in comparison to the returns available from U.S. stocks. By example, companies as measured by the S&P 500 had recently returned substantial cash of well over 4% to shareholders through dividends (1.9%) and stock buybacks (2.4%) over the last twelve months. Many companies return even higher amounts to their shareholders. Recall too, many of these investors have long-term horizons well into the next decade or longer, not later this year. When demand outpaces supply, prices rise.
What about within the market, have all stocks participated in the rebound? Trends already underway in the economy have accelerated tremendously due to changes in behavior during the lockdowns. Many industries are benefiting from these new trends, while other industries are struggling to attract business. Investors have taken note. Prices for the most obvious benefactors of these trends have advanced to extraordinarily high levels even though many of them are barely, if at all, profitable. They are predominantly technology, communications and health care companies. As a result, the Nasdaq Index, which is largely represented by these popular sectors, has advanced a stunning 12% year to date. Meanwhile, the Dow Jones Industrial Average, a group of very notable and profitable companies, remains in negative territory, languishing down nearly 10% for the year.
Where should conservative investors position their portfolios for the post-covid economy? Investor enthusiasm for these stocks benefiting from the pandemic has quickly driven many of their prices to excessive levels. This surge has left many of these companies at dangerously high valuation levels, particularly when compared to other companies within the broad market. This extreme divergence was last witnessed during the dot-com boom, which ended terribly for investors in those glamour stocks!
We have provided a rationale for the stock market’s recent behavior, not a prediction. The future is always uncertain and there are serious risks ahead. As always, but particularly at potential inflection points like we see today, following time-tested investment disciplines is paramount.
Conservative investors should remain diversified across economic sectors. Their portfolios should be populated with well-capitalized, profitable companies. These companies must be capable of returning a large and growing portion of their profits to shareholders in the form of dividends and share repurchases. These businesses, if selected carefully, should benefit considerably, however the current transformations unfold. We believe your portfolio holdings meet this expectation.
INSIGHT INVESTMENT COUNSEL