What IS going on?
The simple answer is massive injections of support globally from central bankers, who flooded the financial system with money, and from federal and state government policy makers who implemented vast transfer payments and other support mechanisms to maintain “paychecks” for consumers and cheap loans and grants for businesses.
These moves in total dwarf the level of support that government entities provided during the great financial crisis of 2008. This tsunami of a liquidity wave drove interest rates down to record levels, which in turn made equities look compelling as an investment alternative.
The global coronavirus lockdown also magnified and accelerated business trends that have been rising for years, such as technology companies remaking the economic landscape. These mega-tech behemoths posted stunning profits and cash flow during the economic collapse of the 2nd quarter. This narrow group of industries and companies became the driving force behind the surge in the overall market indices.
From an economic perspective, the Federal Reserve (Fed) remains a critical element going forward. The Fed today announced the results of a recent review of its goals, policies and tools. The conclusions are effectively “more of the same,” however with some updating of their goals and policies.
The bottom line is that this Fed policy review supports the market’s perception that short term interest rates will remain exceptionally low for a long time, and the Fed will remain vigilant to support markets when needed.
A bigger question that investors are beginning to scrutinize will be policy changes, and especially tax policy changes, after the November election.
Currently it is too speculative to have any clear outlook on this, since it is contingent not just on who wins the presidential election, but also on what happens in the U.S. Senate and the House of Representatives. But if tax rates on individuals, corporations or capital gains are increased, the markets may give back some of the gains that have been posted this year.
What to do?
For an investor who either felt great stress during the last market collapse, or for those whose financial or life circumstances have changed, such that a lower risk exposure to the market is warranted, now is a good time to go through some “de-risking” by reducing equity exposure.
However, investors should always keep in mind the long-term implications of such a move, given that over long periods of time, equity markets have provided returns that are substantially better than cash or high-quality bonds.
In assessing an investment portfolio after such a strong move, portfolio management 101 prescribes looking at where a portfolio is relative to its long-term allocation strategy and making rebalancing moves.
Typical “big picture” rebalancing efforts historically would result in reducing equity allocations back to strategy while increasing fixed income allocations. However, in this environment, where long term interest rates are at extraordinarily low levels, it may be prudent to rebalance to a much shorter-term fixed income alternative rather than to longer-term fixed income instruments.
Cash may be an alternative, as well, but with money market funds currently providing 0%, they may not be an optimal option.
Although long-term, high-quality bonds such as U.S. Treasuries have little appeal, certain segments of the fixed income market offer better relative values, including short to intermediate maturity corporate bonds, mortgage-backed securities and select higher risk markets such as preferred stocks – and possibly municipal bond funds, depending on your tax bracket.
The International Equities Market
The stunning equity rally we have seen has been extremely focused on domestic large cap growth stocks, while international markets have lagged. Now may be a good time to increase allocation to international assets with a modest overweight to emerging market equities.
Foreign economies, and especially Asian economies, are currently less impacted by the pandemic since they went through it much earlier. Also, the dollar has finally begun to trade weaker in the foreign currency markets.
In the U.S. market, the fundamentals continue to support growth businesses and especially large cap growth. Value market sectors such as financials and energy remain challenged by not only the pandemic environment, but by big secular shifts affecting these industries as well.
Small cap stocks are starting to show some “green shoots” of encouraging performance relative to large cap. Valuation of small cap stocks relative to large cap seems compelling, but it will take more evidence from earnings to validate a more significant move into small cap stocks. Thus, it may be appropriate to add some small cap exposure currently as part of a re-balancing, with an eye to more materially increasing an allocation to this sector as confidence in the economy and in small cap earnings improves.
Stay safe and stay engaged and committed to a well-thought-out long-term approach to your portfolio.