Q&A: Risks and Rewards Amid the Pandemic
The Germans have a flair for evocative compound nouns. One of my favorites is “Kraftidioten” (craft idiot). It means someone who is narrowly skilled in their specific craft but obtuse about everything else. Wall Street is full of craft idiots.
You won’t find such people at Investing Daily. Sure, we’re specialists in the investment field. But I’m privileged to work with a lot of smart people who are well-rounded. A rich life experience makes for better investment advice.
Jim Pearce is one such colleague. Jim [pictured here] is the chief investment strategist of our flagship publication Personal Finance. Jim began his career as a stockbroker in 1983 and over the years has managed client investment portfolios for major banks, brokerage firms and investment advisors. Jim has a BA in Business Management from The College of William & Mary, and a CFP from the College for Financial Planning. Like me, Jim is a history buff with a penchant for quoting Churchill.
Jim’s also a cigar aficionado with an impressive humidor in the book-lined den of his Virginia home. The only thing he likes more than a good cigar is making money for readers. I asked him to light up and answer a few questions about the markets. My questions are in bold.
I’m an optimist by nature and we all enjoy reaping stock market gains, but the logical part of my brain is bewildered by this powerful rally. We’re still in the midst of a pandemic-induced recession. Would you concur that the stock market is overvalued and vulnerable to a correction?
By any objective measure, the U.S. stock market appears to be grossly overvalued. If anything, the coronavirus pandemic should have driven share prices lower due to the outsized impact it has had, and will continue to have, on the economy.
Don’t just take my word for it. Warren Buffett, arguably the greatest investor that ever lived, created an indicator that compares the value of the U.S. stock market (as measured by the Wilshire 5000 Index) to this country’s economic output as measured by the most recent quarter of U.S. gross domestic product (GDP). According to Buffett, the stock market is fairly valued when those two figures are at an equal ratio of 1.0. Take a look at the following chart.
In 2008, during the depths of the Great Recession, the Buffett Indicator fell below 0.6. Since then, the stock market has been on a tear. Now, the Buffett Indicator is at 1.8, triple its level three years ago and its highest reading ever. From a purely mathematical perspective, for these two figures to come back into balance either the economy will have to grow by 80% or the stock market would have to shrink by 44%.
At its annual GDP growth rate prior to the coronavirus pandemic (2.5% – 3.0%), it would take the economy more than 20 years to expand by 80%. However, a 44% decline in the stock market could happen in a matter of weeks or months, and in my opinion is the more likely resolution to the current disparity between the economy and the stock market.
The rally is largely driven by aggressive monetary stimulus from the Federal Reserve. What are the dangers of the Fed’s ultra-dovishness?
The Fed doesn’t have much choice at the moment since the alternative is almost certainly an economic depression. However, the long-term ramifications of printing so much money aren’t much better. Eventually, all that debt will act as a drag on the economy once it has fully recovered.
It has been a long time since this country has suffered through a prolonged period of stagflation, which occurs when inflation is rising but economic growth is low. When that happens, there is no simple solution. That is why the Fed has been careful about letting interest rates rise while economic growth is tepid.
Last week, the Fed acknowledged that it must revise its thinking about inflation to enable a more flexible solution to the current crisis. The immediate risk of inflation is low while the threat of a prolonged period of high unemployment is manifestly present. For that reason, the Fed is going to focus on doing everything it can to increase employment even if that raises the odds of higher inflation down the road.
Which sectors and asset classes appear the most vulnerable to you?
If we get a big stock market correction in the near term then all asset classes will most likely suffer. However, some sectors of the stock market are more overvalued than others. Most at risk are some of the mega-cap tech stocks that have seen their share prices explode in value over the past six months.
The energy sector has taken a beating this year due to decreased demand for gasoline while the coronavirus pandemic forces many people to work from home instead of commuting into the office. For that reason, the global inventory of oil and natural gas has increased during the past year despite a drop in production. That means the economic picture for the energy sector won’t improve until well after the coronavirus pandemic has run its course.
I don’t know if the commercial real estate sector is in trouble or not, but it will be interesting to see how many companies allow their employees to continue working from home after the pandemic is over. For that reason, I am expecting to see some dislocation in the REIT sector as commercial properties are converted to other uses. That isn’t necessarily a bad thing in the long run, but in the near term it could impinge on their ability to pay dividends.
In crisis, there is opportunity. How can investors leverage this asset bubble to their advantage?
What we have witnessed over the past six months is something much more extreme than a conventional two-tier market. This isn’t a question of momentum versus value or growth versus income. The six largest stocks in the S&P 500 Index account for more than 25% of its performance, which is why it shows a positive return for 2020. The other 494 companies are still negative for the year.
Therein lays the opportunity for patient investors. There are hundreds of large-cap and mid-cap stocks that are undervalued and should rebound strongly when money migrates out of overvalued mega-cap stocks. You could buy a broad-based index fund such as the Vanguard S&P Mid-Cap 400 Growth Index Fund ETF (IVOG) if you prefer to take a passive approach.
Regardless of which investment approach you prefer, the key is to make your move before asset prices come back into alignment. At some point soon there should be reversion to the mean in both directions. Once the transition gets underway, it could rapidly accelerate.
As September gets underway and the end of 2020 comes into view, how should investors divvy up their portfolios in terms of asset allocations right now?
At the moment, the Personal Finance asset allocation model is 30% stocks, 10% bonds, 15% (inflation) hedges, and 45% cash. Admittedly, our cash position is quite high but I intend to move most of the money back into the stock market if we get the correction I am expecting later this year.
Even though inflation has been running quite low recently, the hedges sleeve of the PF Funds Portfolio has been performing relatively well due to our concentration in gold. The SPDR Gold Shares (GLD) ETF is up 29% over the first nine months of this year.
As for bonds, I do not recommend going out long in maturities since bond prices will eventually fall once inflation starts to pick up. That’s why we own the Vanguard Intermediate-Term Investment Grade Fund (VFIDX) in the PF Funds Portfolio, which has returned 9% this year despite bond yields being at all-time lows.
Is there a big investment story that the mainstream financial pundits are missing?
Yes. At the moment, most of the attention is on a handful of giant tech stocks that are regarded as “too big to fail” until the coronavirus pandemic is over. For that reason, Wall Street is overlooking some emerging trends that will produce the next generation of stock market leaders over the remainder of this decade.
A few months ago, I identified a small company that I believe will be among that group. Since I first recommended it to my readers four months ago it has gained 40%, but that’s chicken feed compared to what lays ahead. I believe it could appreciate more than 2,000% in the years to come if it continues on its current path.
There isn’t enough room to talk about it here, so I have written a full report that explains why I think this stock is about to take off. As one of my loyal readers, you can access this report for free if you click here.