How Indexes Mislead: Performance of the S&P 500 Relative to Other Benchmarks

As of last Friday, the Standard & Poors Index, the basis for index funds under the same banner, had recorded a year-to-date appreciation of 11.29 percent. While this is a commendable number, it was attained entirely (and then some) on Price/Earnings multiple expansion. A year ago, the index had an average P/E ratio of 20.34. It is now 44.41. In a nutshell, stock prices went up while earnings went south. Covid played a huge part in this earnings decline, and the vaccination is expected to play an equally huge role in causing earnings to return. This begs the question: what are earnings expected to be going forward post-Covid? According to published pronouncements from Standards & Poors, earnings for 2021 are expected to be $178.08 for the 500 stock index. If this forecast is accurate, it would imply a P/E ratio based on 2021 estimated earnings of 23.22. In 2022, assuming we can see out that far, earnings are predicted to rise to $202.75, which puts the P/E ratio at that point (assuming no change in the overall value of the 500-stock index) at 20.39. Historically the P/E ratio has been about 16, although it has been subject to a great deal of fluctuation. As the name implies, the Standard & Poors 500 is a composite of 500 stocks of the largest firms in the country. The stocks are weighted by market capitalization, so a large firm like Amazon has more impact on the index than a smaller firm. Six firms make up 22.13 percent of the weight of the index: Apple, Amazon, Facebook, Netflix, Alphabet (parent of Google), and Microsoft. The Standard & Poors also maintains an index of the next 400 firms in terms of size. This index, called the Midcap 400, is up 19.04 percent year to date. A third index of the smallest 600 stocks is up 20.66 percent in this same time frame. Both these indexes are doing almost twice as well as the largest index. What does this imply? First, the S&P 500 index is having some issues relative to the larger market. It included the most favored stocks for so long that their valuations may now be called into question. Last week, Netflix disappointed in terms of subscriber growth, and this led to the stock correcting over ten percent. If companies like Netflix, Amazon, and the like were the chief beneficiaries of the lockdown associated with the pandemic, does it not follow they would be hurt relatively speaking when the economy recovered? In a similar vein, could it be that smaller firms, who bore the brunt of the lockdown, are now ready to take back the business lost to the larger firms? Time will tell as to how much consumers’ shopping habits have been altered by the pandemic. Initial reports are that consumers just want to get out and take their lives back. That could take the form of more socializing and less binge-watching television. It could also take the form of travel, at least within the US this year. Restaurants are scrambling to find staff, which may mean higher prices and slower service. In fact, with a high savings rate, it would seem that higher rates of inflation will be a foregone conclusion. A second advantage the mid-cap and small-cap indexes have over the flagship S&P 500 is a more reasonable valuation. A third advantage is that smaller companies are more likely to already be paying corporate taxes, as smaller firms lack the know-how to avoid paying taxes in the manner of larger enterprises. This means that smaller firms will not feel the impact of the proposed minimum corporate tax rate as much as larger firms, should it be enacted. While the rate at this point is largely undefined, it will be a jolt to the profits of large companies like Amazon, who have never paid taxes due to their heavy investment spending. Companies who play games with keeping their profits abroad to avoid US taxation will also be targeted. Putting all of this together, we may yet have a correction, or we may already have had one. The term to describe leaders falling back and being replaced by other firms is “sector rotation”. A historical example is 1974-82: in this time frame, the Standard & Poors index essentially went nowhere, while the smaller capitalization index tripled. We may be witnessing the same now, as the environment for large companies becomes increasingly hostile. Pressure on large-cap names comes from not just valuations and taxes but also from antitrust, foreign governments’ desire to tax earnings at a higher rate, political and social issues, and privacy concerns. In 2017, the S&P 500 went up 19.4 percent. The chief reason earnings went up that year was the decline in corporate taxes from 35 percent maximum to 21 percent. While we are entering a very strong and recovering economy, should the tax increase be enacted into law, it will impact valuations to the downside. The chief questions are whether the increases will be enacted and when, as well as in what form. The Economy With pent-up demand and a high savings rate, it would seem logical to assume the economy will do well as the lockdown becomes history. Estimates are all over the map, but all are positive. The chief concern at this point is the adequacy of labor relative to demand. Demographically the country has more people dying than being born, even before Covid put its thumb on the scales. Without some sort of controlled immigration, there is no easy way to fix this. European countries have addressed this with worker visas of three to five years. If there is no work, the foreign workers are sent home. Critics say the process is easy to circumvent. In Europe, stiff fines and jail time await an employer who tries to hire a worker with an expired visa or below the legal wage. In the US, the onus has been on the employee rather than the employer. Inflation It looks like America’s efforts to avoid inflation are about to run out of string. The record prices for housing are pressing the inflation rate, as is the shortage of semiconductor chips to build everything from appliances to automobiles. It is predicted that there will be fewer sales when supply is constrained. Right now, there are about thirty container ships outside the port of Los Angles and Long Beach waiting to unload. It is estimated that they hold collectively 45,000 containers of goods for everything from clothes to washing machine parts. Until the logjam is resolved, look for bare spaces on store shelves as a result. Interest Rates Efforts by the Federal Reserve to hold down interest rates may also be running out of options. The Fed continues to champion full employment. However, the combination of jobs being in areas where people cannot or will not commute or move to coupled with a denial by employers as to what is required in terms of compensation to hire, is leading to an impasse in stronger job growth. If wages rise faster than interest rates, the effect will be to cause people to acquire things that they think will appreciate in value faster than inflation overall. Should this mindset take hold, the Fed’s job will be greatlycomplicated. The Stock Market Floating on the liquidity furnished by the Federal Reserve, stocks continue to rise on the backs of higher earnings, low-interest rates, and high demand. Reports of higher taxes under consideration are spooking the market, although nothing has been proposed or voted on. Given the reaction to what has been proposed thus far, the passing of tax legislation may provide a buying opportunity for those that do not hold some of the highflyers which have more compelling valuations. Addition to the Firm Barnett & Company welcomes the addition of Katie Stuart to our staff. Katie comes to us from the banking industry, where she excelled at customer service. Katie is a native of Newport, Tennessee, and an MBA graduate of Carson-Newman University. Katie will be assisting Yvonne Hobbs with client needs as well as serving as the office manager. She has embarked on the CFP program and will be the resident expert on financial and retirement planning. We at Barnett & Company welcome her aboard. Warren M. Barnett, CFAApril 27, 2021
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How Avoiding Risk Can Create Risk: A Primer on False Risk Avoidance

Students of finance become acquainted with what is taught to be the “risk-free rate.” This is the return that can be obtained by investing in securities of the United States Treasury. Usually, the five-or ten-year treasury yield is counted as the benchmark rate, with potential returns taken as some increment of this rate. What makes the treasury rate chosen risk-free is the assumption that the US Treasury can never default on its obligations. Since the government prints money, there is the potential for it to simply print more as their bonds become due. So long as Treasury bonds are accepted and interest rates stay stable, everyone is fine. Since the first of the year, everything has not been fine. The ten-year Treasury yields have gone up only about 7/10 of a percent, but this was enough to cause the treasury bond to decline over 6.9 percent in value. The longer 30-year bond went down over 16.3 percent in the same time frame. While people who should know better remind us that the bonds will be worth face value at maturity, inflation ensures that the nominal worth at that time will not buy what it did when the bonds were issued. Thus, avoiding the risk of default creates a risk of depreciation of wealth- a case study in how avoiding one risk creates another. Investors, especially as they get older, crave stability. In doing so, they sometimes make the fatal mistake of assuming that the volatility of prices is the same as risk. From this mistake, a premium is paid for assets that do not fluctuate in value. Usually, an asset does not fluctuate in value because it cannot be easily priced or sold. Some investors prefer the ownership of a non-traded partnership interest, even when publicly traded real estate offers more liquidity (ease of sale). Most of the investing public considers the stock market to be the epitome of risk, given how much it fluctuates in value. As Peter Lynch, one of the early success stories of investing in the past 40 years, pointed out, the market goes down 20 percent or more at least one year out of three and two years out of five. In spite of this, stocks have a compounded annual return in excess of the categories of cash, bonds, or inflation. Part of the success of stocks at beating other asset classes is that of the potential for rising dividends. As inflation increases sales and profits, often dividends are increased as well. The income from bonds is fixed, and most of the time, cash returns less than the inflation rate, especially if taxes are deducted. The bond market has done well for almost 41 years. After Paul Volcker raised the yields on US Treasury bonds to 15 percent in 1980, interest rates have trended down to the level of close to zero late last year. Higher rates sustained the losses by bonds since. It is safe to say that the long decline in interest rates is over, and as yields increase, bond prices of longer-dated issues will continue to decline. As we enter this new era of rising prices and interest rates, it would seem that assets that retain their value and/or increase their payouts would become ascendant. They will not walk a straight line, but they have a better chance of maintaining purchasing power than investments that get run over by higher rates of interest. All this puts the risk-averse investor in an awkward position. They can either accept volatility and ride it out or seek investments that are not volatile and hope they maintain their purchasing power. Risk-aversion is almost a universal human trait. The problem is that, sometimes, aversion can carry as much cost as risk, if not more so. Even in stocks, risk can be measured best after the fact. In general, the less a stock has in terms of a dividend, and the higher its price relative to its earnings, the greater the potential for gain and risk of loss. In terms of the overall market, data would tend to support the idea that stocks, in general, are generously valued. The problem is, no one knows how long this can last. The Economy The signing of the $1.9 trillion stimulus bill seemed to have thrown a switch on the US economy. Forecasts now call for accelerating economic growth for the balance of the year. Fourth-quarter numbers are for as much as a 6-8 percent gain year over year. While revenues are expected to be up across the board, the cost of borrowing to stay afloat will hit some companies hard. There are some firms that were forced to sell additional stock to keep their doors open.They will find earnings progress especially painful, depending on the number of additional shares sold. Interest Rates Interest rates, which have gone up since the first of the year, will go up more. The increase is the first of any size in the memory of many investors and has been an unwelcome jolt on the stock market. Many investors in the stock market are not there by their own choosing, but because returns on cash and Certificates of Deposit are so low. As interest rates move to be over two percent for the ten-year treasury yield, look for money to move back into short-term cash investment from stocks. Also, look for the spread between non-investment debt and investment-grade to widen. Finally, muni debt at some point will also be impacted by the rise, although talk of higher taxes somewhat curtails the adverse impact for this category. Inflation Inflation predictions are for sharply higher rates. The debate seems to be whether the increase in the inflation rate will be temporary or ongoing. At this time, the predicted tightness in the labor market would argue for ongoing. This will change the complexion of investing going forward. The Stock Market Stocks have had quite the roller coaster ride to date. The Dow-Jones average is up 6.7 percent, while the Standard and Poors 500 is up 4.6 percent. The index for the over-the-counter market, the NASDAQ, is up only 3.4 percent, reflecting its technology dominance, while the Russell 2000 index, which has more small and fewer technology companies, is up 14.6 percent. Going forward, there is a high expectation that smaller stocks will do well with the stimulus and stronger economy. Should this not be the case, a reaction will be swift. A Note from the Founder I have been informed that certain members of the firm will be leaving shortly to start their own venture. It has been described to me as focusing on financial planning and exchange trader products. You will be no doubt notified of this decision in short order. As of now, your contract is for the services of Barnett & Company. While we welcome your patronage, this is your money. If you decide to transition to the new firm, you will need to fill out paperwork for that purpose. If you do not fill out such forms, your investments will stay with your current provider managed by us. Please call me or Yvonne Hobbs should you have any questions. 423-756-0125. Warren M. Barnett, CFAMarch 22, 2021
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GameStopped: Revenge Of The Internet On The Hedge Funds

If one goes back to the beginning, it can be surmised that the main reason for the creation of what became Wall Street was to raise capital for business and government. From the early brokers who gathered under the Buttonwood Tree in Lower Manhattan in 1792, the chief rationale of the stock market was to finance the future of the country. For most of the first 125 years, stocks were considered a riskier but potentially more rewarding version of a bond. Common stocks were sold with a capital value of as much as $100 per share, which was their capital contribution. Common stocks were sold with a stated or implied dividend. If business was good, stockholders received an increase in their dividend, something other securities did not do. While corporations were under no legal obligation to pay the dividend (unlike some preferred stocks and all bonds), missing a payment would usually set off a crash of the stock and a denial of access to the capital markets to the company. Stock manipulators like Jay Gould and Elliot Fisk tried to take over companies with stock that had been issued but not paid for. This was known as “watering down” the stock, as the corporation’s capital account did not receive a monetary benefit from the shares issued. This was illegal, but prior to the invention of the Securities and Exchange Commission (SEC), it was caveat emptor. After World War I, stocks were bought less for their dividend income and more for their earnings prospects. The 1920s ushered in the automobile, electrification, the telephone and radio, motion pictures, all of which enticed people to invest in the limitless future of these emerging and disruptive technologies. Often, if stocks paid a dividend, that was an afterthought. The investment idea was to capitalize on the trends. All of which led up to 1929. So many people had used borrowed funds to invest that when the market turned down, they were forced to sell out of their holdings. This created a cascading effect, which resulted in the market’s fall in 1929 and 1930. Once again, stock yields exceeded those of bonds in the 1930s and would remain so until after World War II. Today, we are witnessing another transition. Through the internet, hundreds of thousands of unversed speculators are being harnessed to focus on a few stocks. As this is being written, the stock of GameStop (a game retailer that was previously destined to go the way of Blockbuster in the video rental industry) has suddenly become a hot stock, having doubled in value just yesterday. This is the result of two things: a cabal of short-sellers who thought the company was going bankrupt and a legion of internet investors who wanted to make life miserable for the short-sellers. Think of it as populism meets capitalism. Short sellers focus on stocks that they think are going down in value, ideally to zero. They borrow shares from a brokerage firm and sell them, promising to buy them back later. As the stock declines in value, the account of the short-sellers increases. Sometimes, short-sellers publish “research” on the internet to support the idea that the stock being shorted is toast. In the case of GameStop, the effort backfired. Online brokerage firms like Robinhood aspires, on their clients’ cell phones, to promote endless trading of which they receive a fee (forget the deception of “no commissions”). Investor platforms like Reddit discovered through public information that GameStop stock was 105 percent short. This means that the brokers who sold the stock short did not collectively have enough stock to cover their positions. In the ensuing melee, GameStop’s stock oscillated between $10-500 per share before the SEC and brokerage firms stepped in to “maintain order” by making the stock more difficult to trade. By so doing, they were trying to drive down the price supposedly to protect the speculators but really aiding the short-sellers, who were at this point out billions of dollars. The brokers who sold them the shares short were facing ruin at the run-up prices if the hedge funds could not cover by buying back. While some may see this as a victory for the little guy against the hedge funds who orchestrated the shorts (at least until the brokerage firms and SEC jumped in), it is also a commentary on how much the stock market has, in places, become a casino, and certain stocks no more than casino chips. A second lesson to be learned is the ability of this short-squeeze trading to spill over into other parts of the stock market. If people buy GameStop at $500 a share, only to watch it go to $100, will such an investor have to sell other holdings to meet their own margin calls? This is how the events of 1929 cascaded out of control. We have gone far beyond the Buttonwood Tree. If the market is to provide a place for investors to set aside funds for their retirement, it will need to address those who want to make it a casino. Brokers and speculators love trading, but investors need positive returns over time. There may be a way to accommodate both; if not, investors need to come first. Recall the original purpose. The Economy Not surprisingly, economic data is now viewed with political overtones. With a $1.9 trillion COVID relief bill pending, such is to be expected. The reality is that the economy is still hurting. People are still being laid off in higher numbers than pre-COVID, especially in the service sector that disproportionately employs women. One in 20 homes cannot stay current on their rent or mortgage. On the other hand, vaccination progress is material. COVID cases are going down. Depending on who is being quoted, some semblance of normality is 3-9 months off, assuming no significant mutations that current vaccines cannot handle. What seems to be forgotten is that the funds being legislated can only be spent if people qualify for the same. If the economy were to recover quickly, the money would not be spent. Those who worry that the stimulus will go to those not needing it should consider surtaxing it. Someone of a higher income will repay the government more than someone in a lower tax bracket. Embedded in the bill at this time is not only an increase in the minimum wage to $15 per hour, but an expansion of who is covered by the minimum wage laws. In the restaurant industry, hourly wages can be as little as $2 per hour if tip income makes up the difference to $7.65, the current base. If restaurants, hotels, and others who hire those who rely on tip income need to pony up the difference to $15 per hour, the effect on prices could be substantial. Interest Rates Interest rates are going up. The combination of the sheer volume of government bond issuances and higher perceived returns in non-interest investments like stocks, Special Purpose Acquisition Companies (SPACs), and private equity are all eroding support for bond values. Depending on the decline, this could be a major theme of the next few years. The ten-year Treasury yield is currently 1.40 percent, and the thirty-year is 2.25 percent. Both are up from the first of the year. Inflation Inflation is becoming harder to explain away. The falling dollar and international economic revival are stoking commodity prices to their highest level since the last expansion. Even computer chips, once considered almost a commodity, are in short supply. Add to this the inflationary implications of the higher minimum wage, and the stage is set for the first round of sustained inflation in a generation. What happens next is a matter of credit availability and mindset. There are those who believe that consumers, having been denied the ability to spend money on services during COVID, bought goods instead. They may be shocked at how much more the earlier services now cost. The Stock Market Since last fall, there has been a shift away from high valuation growth stocks to lower-valued value names. Depending on how high interest rates rise, this may be a trend with some duration. Higher interest expenses will affect companies in proportion to their leverage. For the most part, the effect will not be felt all at once but rather over time as debt is reissued at higher rates. An offset may be the stimulus spending and higher minimum wage, depending on how it is structured. Studies show that those on the lowest income levels tend to spend income increases disproportionate to those receiving at higher income levels. The ability of the economy to sustain itself is key to the market’s performance in 2021. Warren Barnett, CFA
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After 2020: Ready For 2021? Insights For The New Year

This year will be best recalled as one where the economy went down, and the stock market went up.  After suffering a 30 percent contraction in March and April, the GDP came back forcefully in the summer, only to fade out in the closing months of the year.  The stock market continued to hit new highs as the year progressed.The most harmed parts of the economy were also uniquely different this time around.  Usually, an economic contraction occurs most in cyclical manufacturing industries, while services are less affected.  This time around, the vortex of the economy’s collapse centered on the travel and hospitality industries.  Initially, this was not so much the result of reduced demand as constrained access to supply.  In the lockdowns to slow the spread of Coronavirus-19, businesses found themselves oftentimes at a disadvantage to serving the customer, if government edict permitted the customer to be served at all.  State and municipal governments, with income in a free fall, are being forced to retrench and lay off.  Even now, the most recent applications for unemployment benefits are running three times their number before the pandemic hit.The second difference in this economic downturn is the representation of small businesses, which are being disproportionately taken down relative to their larger competitors who have better access to capital to tie them over.  Independent restaurants are over-represented on this list, as are clothing stores, retail, gyms, spas, and salons.  Bars, entertainment venues like theaters, and firms catering to business or vacation travel have been decimated.  For many non-profits, it has been a nuclear winter, as exposure to both donors and the public is drastically reduced.Now that we have two vaccines, with more to come, it is expected that we will see an eventual end to this pandemic.  However, the country and the world will be a different place going forward.  The vaccination campaign is expected to show positive economic results by the second quarter of 2021, with more momentum for gains coming in the second half of the year.  Still, many firms have borrowed heavily, mortgaging their recoveries in the process.  Many smaller businesses will not get help in time to survive.There is also the matter in 2021 of a new president and a divided congress – subject to the vote in Georgia over their two Senate positions on January 5.  Whether this will be a repeat of the gridlock seen when Obama was president is at this point unknown.  The Biden administration is expected to be more centrist.  If so, some Republicans may want to join them in passing legislation.  This assumes administration-desired legislation gets to a vote, which does not always happen in a divided government.Finally, there is the matter of the rest of the world.  For whatever reason, many parts of the world have coped with the coronavirus better than the United States. With five percent of the world’s population, the US recorded seventeen percent of the covid-19 cases and deaths.  This has led to far greater economic growth in 2020 being recorded in Asia and elsewhere than in the US.  We may have reached a point where the world does not depend on US growth to prosper.  This has implications for everything from the centrality of the US dollar in international trade to our ability to influence foreign conduct to our advantage.  In fact, the dollar is now down thirteen percent in value from last March 1 relative to other currencies.The decline in the US dollar has a number of adverse implications.  If foreign investors’ portfolio investments in US dollar assets lose value due to the dollar’s depreciation against their home currency, then investments in dollar assets become less attractive.  This could lead to a demand for higher interest rates to compensate for the currency’s decline.  Higher interest rates would blow a hole in the US budget, as the US government is the largest issuer of US dollar debt in the world.  It would also reprice interest rates for other assets higher as well, complicating the efforts of businesses to increase profits without a price increase of some magnitude to compensate for higher interest expense.Higher interest rates would also cut the ground out of one of the tenants of Modern Monetary Theory (MMT).  This theory, which has largely been used to explain and justify the expansion of stock prices for the past decade, rests in part on the assumption that there are so many investors looking for returns, the trend was and will continue to be one of low and falling interest rates, high market valuations, etc.  Those of us who have been around a while have seen this movie before.  It does not end well.While not all the stock market is generously valued, there is sufficient euphoria to drive the indexes up.  When a car company that did not exist a decade ago has more value than one that has been around for a hundred years, you have to wonder.  This car company, Tesla, joined the Standard & Poors 500 last Monday as the fifth largest position in the index.  Buckle up and enjoy the ride. The Economy The $900 billion stimulus bill passed on Sunday has not been signed into law as of this writing. Assuming it is approved, distribution of the funds is not expected to impact the economy in December 2020 and only marginally in January 2021.  They will, with the progress on the vaccinations, help to provide a better year-over-year progress in the second quarter and the second half of 2021.The strongest recoveries will be staged by the industries most adversely impacted in 2020.  Recovery will be constrained by the amount of debt assumed by some firms during the pandemic, as well as their domestic versus international orientation.  Interest Rates As mentioned earlier, a weaker dollar at some point will require higher interest rates to compensate for the risk of it falling further.  This would seem to imply an ongoing slide, which, hopefully, will be orderly enough not to induce panic selling. At this point, look for a ten-year US Treasury yield of 1.25-2.00 percent before year-end 2021, with the 30-year treasury to be around twice the ten-year quote.Such a shift will affect bank lending rates, as well.  This could impair ventures that depend on the low cost of funds to become viable investments.  Inflation A falling dollar makes imported goods more expensive in dollar terms.  Thus, commodities like copper, iron, oil, and the like would be priced higher in dollars even if they are constant in foreign currencies. The second source of inflation is the commitment to a $15 per hour minimum wage made by the Biden administration.  While to be implemented over a number of years, it could start a wage spiral that will result in higher prices.Depending on who is doing the counting, inflation is now around two percent.  Expect that to be up to four percent by year-end 2021. The Stock Market Stocks have recently shown an expansion of the number of issues participating in the rally, which is a healthy development.  Still, through December 18, the Standard and Poors 500 is up 14.3 percent, mainly on the backs of a handful of issues (Amazon, Facebook, Netflix, Apple, Google, and Microsoft) that make up about 22 percent of the index.  The addition of Tesla will concentrate performance further still.  The Nasdaq Index, where these issues make up 46 percent of the value of the index, is up 45 percent. The issue is whether the past will be prologue.  Of the seven companies mentioned above, three (Amazon, Facebook, and Google) face antitrust issues both here and in Europe.  Netflix is confronting competition from the likes of AT&T’s Warner Media as well as Disney.  Tesla, which made about 400,000 electric cars last year, now has competition from the like of General Motors, Mercedes, BMW, and others.  2021 will be a very interesting year for investing indeed.  Warren M. Barnett, CFADecember 23, 2020
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Waiting For The Calvary To Arrive: What A Vaccine Will And Won’t Do For The Economy

As the Coronavirus continues to stalk the land, killing at last count over 260,000 Americans, word of at least three vaccines have been delivered for FDA approval.  Distribution in some capacity is to hopefully commence by December 18.  Mass inoculation is expected to take place soon after approval, and most of the world should be vaccinated by the fall of 2021.All of this is wonderful and a testament to modern bio pharmacology.  Still, even with this advance, the Center for Disease Control and Prevention (CDC) forecasts 440,00 Americans dying from the virus by the time it has run its course.  This figure assumes people will be receptive to being inoculated with the vaccine as it becomes available, a big assumption at this point.  Even with the delivery of the vaccine, the number expected to die exceeds the death toll from all Americans in World War II.  There is no data yet of those who will live but have lingering aftereffects, from mental impairments to compromised respiratory and motor skills.  In many respects, the Covid-19 virus has damaged the country in ways the Great Recession never did. Many investors are expecting a return to pre-Covid-19 prosperity with the vaccine in 2021.  That is not likely to happen.  While Americans will return to some routines enjoyed before the pandemic hit, it is not likely that life will revert to status quo ante.  One reason will be that many of the things enjoyed prior to the virus may not be available.  Already over ten percent of restaurants have closed their doors, and the estimate is for 30 percent to shut down if the holidays do not provide a pickup.  The same is true of many other forms of retail and entertainment such as apparel, department stores, theatres, nightclubs, and the like.One less obvious victim of the pandemic may be the era of easy money.  While the Federal Reserve will do what it can to keep interest rates low, foreign investors who buy the debt that finances the government’s deficits are showing signs of nervousness.  One reason for the concern is the tug of war over the transition of power, an event that is making the US look like a country whose institutions are no longer respected by its own people.  Why should foreign bond buyers trust in the value of the dollar when the country backing the same cannot conduct an election that both sides will respect?A falling dollar is supposed to be good for an economy.  It makes imported goods more expensive and thus less competitive.  At the same time, domestic exports become more competitive due to being lower in price in foreign currency.  But if interest rates need to be raised to prevent the decline from becoming a rout, then a key element of control of the country’s finances will effectively pass to foreign interests. While control of the Senate will not be resolved until January 5 or so, Republicans have already indicated that they are not interested in continuing government spending going forward to match the amounts appropriated earlier in the year when the virus first hit the country.Republican fiscal rectitude seems to be a function of who controls the White House, witness the approximate $6.7 Trillion in red ink the last four years that added an equal amount to the country’s indebtedness.  In terms of deficits, this may be the time when the music stops.The reality is that there are over 20 million Americans out of work due to the Coronavirus.  Almost all programs put in place to address their plight will terminate on December 31.  With another round of lockdowns beginning, more will join this number.  For many, it will be a cold winter, no matter what the weather forecast says. The EconomySince part of the emergency spending to address the pandemic ended September 1, the economy has been showing signs of deceleration.  The deceleration was offset somewhat by the high savings rates of earlier this year. The remaining programs are set to expire on December 31, and lockdowns are again becoming more prevalent in response to higher infections and mortality rates.The economy is set to slow down even further.  Economists at JP Morgan Chase bank are expecting the economy to decline 1 percent in the first quarter of 2021, after growing 2.8 percent in the fourth quarter of 2020.  JP Morgan expects the economy to return to growth in the remainder of 2021, but only after a $1 Trillion stimulus package is passed into law sometime in the first quarter.  In terms of sectors, farmers are perplexed that there is a shortage of containers to ship grain to foreign buyers.  It turns out that foreign sellers can use the containers to ship more expensive goods to the US, send them back empty, and still make more than shipping grain.  Other goods pay up to eight times more than farm output for shipment in containers.  If the containers are used to ship bulk items like farm output, the containers need to be cleaned out after use, which makes grain shipments even less attractive to the shippers. Interest RatesInterest rates will remain low for the foreseeable future if the Federal Reserve has its way.  The question is: will they be in control in an environment that has always depended on foreign investors financing our government deficits, but seldom to the extent that is true now.  Expect interest rates to begin to climb upwards. InflationAs mentioned previously, cheap money has found an outlet in financial markets.  Instead of consumer price inflation, we have witnessed record-high stock prices and lows in interest rates.  Any number of business startups have been funded that never would have seen the light of day were interest rates higher. If interest rates do go up, expect to see inflation rates to follow.  Also, it seems that there is more talk of a $15/hour minimum wage indexed to inflation.  While such a wage will make more Americans who work for the minimum wage ineligible for government assistance, it will be inflationary.  How much so depends on the time frame for implementation.  Florida passed a $15/hour minimum wage law for their own state during the election.  The Stock MarketBy most valuation metrics, the stock market is overdue for a correction.  An accommodating Federal Reserve has held a correction at bay.  Yields on non-investment grade bonds are down to 4.8 percent, a record low. The issue is how much more will the rest of the world back the US, given its perceived political instability.  Sectors that should do well in 2021 are commodities, companies that should spring back from 2020 like transportation, and industrial firms that can profit from a falling dollar. Warren M. Barnett, CFANovember 25, 2020
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Can the Election Winner Influence the Stock Market? Not in the Way You Think

Many investors have decided to wait until the election is decided before investing in the stock market. Based on history, there is a two-to-one chance; this is a bad idea. What an election does is eliminate the uncertainty over who will win. This uncertainty holds stock prices back more than the programs of the candidates themselves. A recent story in the Wall Street Journal bears this out.  It is fashionable to believe that if one party or another wins the White House, there will be some stock market crisis.  In reality, even if there are enough electoral votes (270) to name a winner the day after, the next government is not installed until January 20 of next year.  This delay leads to all kinds of punditry as to who will be impacted.  At the same time, programs that may be affected have time to lobby to minimize, if not eliminate, the adverse impact.  For example, people assume if Biden and the Democrats were to carry the presidency and Senate and keep the House, all manner of tax increases would be introduced. With almost three months to lobby, most pushes in this direction will have a chance to be watered down.  Also, if the use of the tax increases is to launch infrastructure programs and help pay for the COVID vaccine and its distribution, one could argue that the funds were judiciously spent. If the Presidency and the Senate were to stay in Republican hands, an assumption would be that taxes would not be raised, and deficits would continue to mount.  With interest rates so low, this is not the immediate end of the world were such to happen.  The Federal Reserve is on record as not seeing interest rates rise before 2023 or 2024, the latter date in time for the next election. The ultimate can-kicking scenario. If there is a delayed outcome to the election, the lag in results would not be good for the market.  The pre-election uncertainty will not be resolved.  The last time this happened was in 2000 when Florida’s outcome was delayed by a recount.  This was also the time that the air was beginning to go out of the dotcom bubble. The corresponding decline of the tech-heavy NASDAQ index by almost 50 percent over the following two years also impacted other indexes, to lesser extents. Longer-term, what will guide the market is earnings, interest rates, and valuations. All three of these factors are intertwined.  Earnings depend on economic growth, both domestically and abroad.  Interest rates are under the presumed control of the Federal Reserve. However, the dollar’s falling in value as an international currency seems to indicate that, at some point, that control will be questioned.  Median valuations are as high as 1999-2000 in part due to the virus-induced contractions in earnings, which is not a good omen for the overall market.  Of these three factors, interest rates are the key.  When they start to trend upwards, other areas will feel the pressure. This year has been one of convulsions.  The induced shutdown of the economy in March was unprecedented.  The funds appropriated by the federal government kept any number of businesses and individuals afloat.  However, funds ran out in August, and new funding does not appear forthcoming in the near term.  The Federal Reserve has publicly stated that it cannot hold up the economy on its own. Still, the Senate refuses to take up a House bill to continue funding even though it cannot pass one of its own. The issues are political, ideological, and social.  It may be asking too much of a single election to resolve all these issues. A vaccine will help resolve the environment, but the other matters are perhaps outside the domain of medicine and public health. One step to national reconciliation would be to hold the distribution of content on the internet to the same standards of libel as print publications.  In the early days of the internet, when it functioned more like a bulletin board, internet content was exempted from site verification on the grounds that the distributors of information were not financially capable of editing what was posted for truth and accuracy.  Given the vast sums earned from advertising on the internet, it would seem a matter of public policy to review that exemption.   In the 1800s, so-called “yellow journalism,” essentially the publishing of sensational and misleading information, flourished.  Several newspapers in a given market wrote such stories while jousting for readership and advertisers. This largely came to an end when papers were successfully sued for libelously publishing misinformation.  The Economy The economy is being sustained by two factors.  The first is the previously mentioned government aid, which was sometimes distributed without a test for financial need.  The $1,200 per eligible person checks were distributed to all who did not have taxable income over $75,000 as individuals (or $150,000 as married couples filing jointly) – with a steep reduction in benefit above those thresholds – fall in this category.  Many families deposited these funds into a bank account or used the funds to pay off debts.  Along with the $600 per week Federal Unemployment benefit and whatever state benefit being earned, some people had take-home pay higher than their net paychecks. Criticism of the higher net amounts helped keep an extension from being passed into law.  As time goes on and there is no replacement, the lack of buying power will make itself felt.  Forecast of retail spending for the Christmas holidays now estimates a ten percent decline compared to last year. The second source of economic support is the spending of seniors.  As consumers who by and large do not work but who collectively have sustainable investment assets, senior citizens are in effect a private sector economic stimulus program in and of themselves.  Further, as Medicare and Social Security recipients, the over 65 group receives government assistance not available to most of those younger.  Interest Rates  After hitting new lows mid-year among talk of negative interest rates, yields on US Treasury assets have begun to tick upwards.  When the ten-year note hits one percent (currently about 0.74 percent), there will be a wake-up call of some magnitude. Moving that wake-up call along is the weakness of the US Dollar relative to other currencies.  As the dollar falls in value relative to other currencies, the performance of US stocks improves in foreign currency terms.  At the same time, foreign goods tend to cost more domestically in dollars, helping to fuel inflation and higher interest rates.  The Federal Reserve has predicted that interest rates will not go up until 2023. However, their ability to hold rates down may be tested by a stimulated economy on the one hand and a falling dollar on the other.    Inflation  Inflation expectations are being downplayed by the government, who, as the world’s largest creditor, would have the most to pay if they were raised.   The 1.9 percent increase in Social Security to pay for price increases in 2020 is a joke.  No one will provide the data as to how the figure came about. This will be a figure of some focus going forward, as those who depend on Social Security cannot keep up with the actual increases in the cost of food and housing.  The Stock Market  Year to date, the market is flat to up ten percent, depending on the index being used.  A technology component moves the indexes higher, just as in 1999 and 2000. The market seems to have great faith and expectations in a massive stimulus program early next year, accompanied by a boom in domestic demand and stronger economic growth.  Should this scenario not prove out, the level of the market relative to historic standards makes it vulnerable to a correction.   Warren M. Barnett, CFAOctober 26, 2020
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Party Like It’s 1999: The Return Of Day Trading And Its Impact On The Markets

During the internet boom of the 1990s, a culture of day trading bloomed.  The speculators tried to guess the direction of a given stock and pile into it if the direction was perceived as up.  When the gains tapered off, the stock was dumped.  By doing this several times a day, the day-trader could potentially earn high returns on his or her capital.  They could also lose their shirts, as most of them did in the ensuing crash.Unfortunately, the market became more volatile than the traders could get in front of.  Trying to “buy the dip” became a suicide mission, as the market began to go not only up but down.  As the internet stocks began to show their inability to match their growth prospects, prices went lower still.  In the end, most day traders lost money, and more than a few got wiped out.Fast forward to 2020.  With so many people impaneled at home due to the coronavirus pandemic, and with the introduction of apps on smartphones like Robinhood that permits people to trade their accounts anywhere, a new generation of day trading has come back to the stock market at full force.  As before, people are trading stocks and other securities based on their momentum.  If a stock goes up, speculators pile into it.  When the momentum shows signs of waning, the same parties look to bail, to go on to the next idea.  This time around, not only are stocks and options being traded, but commodities and currencies are as well, mostly due to the existence of an Exchange-Traded Fund (ETF) unit, which permits investors to do so.   Like the previous day trading boom, people are often speculating with their retirement accounts.That this will end badly is a given.  The question is how badly.  The crash in oil in March, when the posted price briefly went negative, showed several shortcomings of the day trading strategy.  For one, traders are not only competing with each other, but also with computer algorithms that sense the turn in prices faster than any individual trader. Such computers can see all the market trades in a security at a given time, and thus it has a perspective that no individual trader can match.  Because brokerage firms get compensated for matching up trades or flowing the trades to someone who can, the computers see the orders before they are executed.  This is equivalent to a gambler betting against the house when the house gets to see the cards before they are dealt.Add to this the fact that many day traders are dealing in securities that they do not understand, such as put and call options.  Some use leverage (borrowed funds) that can leave them with substantial liability if the trade does not work out.  The image of children playing with matches immediately comes to mind.Before thinking this is just a fringe activity, consider this: in 2010, just over 15 million option contracts were traded per day.  So far, in 2020, the volume is 27.5 million.  Trading in gold and silver is getting so voluminous that the ETFs are having a hard time finding enough physical metal to back the ETF units. Internet chat rooms talked up the stock of companies like Hertz and JC Penney to the point the stocks tripled, even after they declared bankruptcy and their pre-bankruptcy common shares were declared worthless.  E-Trade opened as many accounts in June as all of 2019.In Wall Street, there is a term for providing a supply of investments to such clients who ignorantly trade more on rumor and stories than on facts.  It is called “feeding the ducks.”  Investing takes time and research, and while assumptions have to be made, it is usually longer term.  Speculation requires none of this, only a desire to get on something when everyone else does and get off before they do.  In this sense, the name of the app Robinhood is appropriate. What is less obvious is who is being robbed.Even the more “conservative” day-trading speculators who only trade market index options like the Standard & Poors 500 can roil markets in the short run.  Currently, each time a share of index ETF symbol QQQ is purchased for speculation, around 36% of the funds flow into five stocks:  Amazon, Facebook, Netflix, Alphabet (Google), and Apple.  When the units are sold, the same happens in reverse.  Given that day-traders go in and out of their positions so often (holding for 24 hours is considered long-term), their ongoing impact on a broad index is considered minimal compared to the short-term moves in certain individual stocks. A study in England showed that almost 80 percent of day-traders lose money.  In spite of this, the lure of fabulous gains brings them back and keeps them often going until their capital runs out.  One immediately sees the parallel to gambling addiction.  In fact, some people say that the current lack of professional sports activity is fueling day trading as there are fewer sports games to bet on. That will be proven with the passage of time.  Until then, attempt to stay out of the sectors of the market that are even more over-valued than the market itself, which is not exactly a bargain right now based on historical metrics.   The EconomyWith the expiration of the $600 per week Federal Unemployment Benefit this week, and as of this writing no agreed-upon replacement, it would seem that the economy is heading to some sort of short-term contraction.  With over 1.5 million workers laid off weekly, the economy currently appears in equilibrium between jobs coming back (such as in health care) and jobs being shed in hospitality, transportation, state and local government, and the like.                    There is some hope of political compromise.  It is understood that the President is in favor of another round of $1,200 checks per household (with his signature affixed).  What rate, if any, the monthly unemployment rate will become is at this point anyone’s guess.The going assumption is that everything is in holding until a vaccine can be developed and distributed.  When this will be, and how long consumers and businesses can hold on is the question. Interest RatesThis past June, the federal deficit for the month was more than the entire year 2016.  Fiscal year to date, the deficit is $2.7 Trillion, with three months to go until the end of fiscal 2020.Much of the extra debt issued to finance this deficit has been purchased by the Federal Reserve.  We are fast approaching a point when the ability of the Fed to finance the deficit may be running out of string. When that happens, who is next in line?   China, who holds more US debt than any other country, is letting their portfolio mature while not making any more purchases.  It is thus assumed that by the end of the year, interest rates will have to rise to find more buyers.  Recalling 2018, the prospect of rising interest rates seems to be the issue the stock market is most afraid of. InflationAs mentioned previously, the best place to look for inflation is in security prices. For its own reasons, the government does not do so.  Based on goods purchased, inflation is rather tame, if rising.  Services are less tame but also rising.  Remember that this is in an environment where demand in many areas has been suppressed due to the coronavirus.One development that bears watching is the decline in the value of the US dollar relative to other currencies. This has inflationary implications, as a cheaper dollar requires more dollars to buy the same volume of imports from the exporting country. This would permit domestic producers to raise prices, knowing that imports could not compete. It would also make our exports more competitive, assuming a free market for such goods, as it would require fewer units of the foreign currency to pay for the domestic export.  Thus a falling dollar may be good for business, but less good for the consumer.The Stock MarketSince March, stocks as a group have shown an ability to rise almost regardless of the external environment.  Many of the valuation yardsticks do not seem to apply to at least some sectors.  How long this will continue is anyone’s guess.  It is expected when the estimates for 2021 earnings come out in the fourth quarter, there may be some reality introduced to the equation.  Until then, evaluation is the order of the day.  Warren M. Barnett, CFAJuly 27, 2020
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“This Too Shall Pass:” Notes on the Investment Environment Going Forward

After five weeks of quarantine, many people are wondering when, if ever, life will return to normal.  The short investment answer is that it won’t.Even after a vaccine is found, the ramifications of the Coronavirus pandemic will persist.  The event has exposed fault lines in society that will not easily be papered over.  It has also revealed the extent of how both the Federal Government and private entities have relied on debt to keep economic good times going.  It is surmised that credit will not flow so quickly or so cheaply going forward when compared to the past twelve years.One would have to go back to 1912, to the sinking of the RMS Titanic, to find an equivalent social movement born out of a disaster.  The Titanic was considered an engineering marvel, an example of maritime progress.  However, after it sunk and inquiries were conducted, it was noted that of the 1,500 people who perished, almost all were below deck in the steerage compartments.  Of the 600 people who survived, most were first-class passengers.  It seemed the ship had only enough lifeboats for the upper deck and none for below.  The ensuing public furor over this marked the end of the Edwardian Era.  Up to that time, the life of a commoner was considered of less value than the upper class.  The Titanic’s discriminating loss of life was reinforced with the prosecution of World War I.  Commoners were conscripted to march into a meat grinder of trench warfare, while upper-class members were enlisted as officers who often directed the carnage from a distance.  By the 1920s, Britain was taxing estates at a rate up to 120 percent; such was the contempt of the commoners for the elites.Something similar is happening now, with African Americans dying from the Coronavirus at 2.5 times greater than their share of the population.  The number of workers without masks, protection, health insurance, paid time off, or a living wage has been laid out for all to see.  These conditions are expected to find a political outlet. For some, it will not be pretty when it does. The propensity of government to raise funds it does not have to offset the mass quarantine is staggering.  So far, $4 Trillion has been committed.  Before it is over, another $2-4 Trillion may be raised.  For a country with a $24 Trillion economy, but $20 Trillion in government debt, this is a significant number.  Any attempt to pay this debt down by raising taxes or running a surplus will be a drag on the economy.  Even before the virus came along, the government was running a deficit of $1 Trillion per year.  In this sense, the Coronavirus did not so much change the fiscal course of the US as to accelerate it.The consequences of these trends would seem to be: first, higher interest rates, as the US taps into a shrinking pool of international assets for investment.  Second will be higher inflation, as the income inequalities exposed by the Coronavirus is addressed by a higher minimum wage, expanded healthcare benefits, etc.  Third will be more subdued financial markets, where investments will have to be benchmarked to a higher interest rate and lower earnings per share growth to evaluate their value.  Hedge funds that have enjoyed a privileged tax status will have it rescinded.  Private equity will no longer have borrowed money plentiful at low rates, impacting the ability of an investment to pay both the managers and the investors.  Stock buybacks with borrowed funds will be a thing of the past.Superimposed on this environment is the ongoing decline in population growth due to our stringent anti-immigration laws.  Without population growth, an economy can only get bigger through either borrowing or exporting.  Until the US dollar materially weakens, and other countries are willing to overlook various policy differences and insults by the US, it is not expected that exports will be a material source of growth going forward.This is not to say there will not be any investment opportunity. Healthcare will continue to grow, although the more political parts may be leveled by government edict.  The growing retired segment of the population will, in time, go back to taking cruises, trips, eating in restaurants, etc.  In fact, such activity will probably be considered a private sector stimulus to an economy that will be contending with reduced government spending in the form of lower deficits or even surpluses.The issue is whether the entire stock market will advance.  The answer is probably not at the rate of the past decade.  The loss of stock buybacks will take away a material source of stock demand.  Rising dividends in time will take up the slack, especially as the cash return on stocks is compared to the return on short-term debt.The world going forward will look different from the world of even a few months ago.  Out of such changes, investment opportunities are formed, and threats to the established order are created.  Thus investing resembles nothing so much as a chess game that never ends.  Play a long game, and play well.The EconomyThe economy is in a state of induced coma.  The consumer, who makes up 70 percent of the economic activity, has been dispatched to dwell in self-isolation with the exception of those considered essential to the community.  In all areas, hospitals and first responders are considered essential, as are grocery stores.  Beyond this, the list gets murky.  Liquor stores in most localities are considered essential, whereas seating in a restaurant is not.  The idea is to avoid congregating unless necessary.  The result is an unemployment rate north of 15 percent. Reviving the economy will take some finesse.  There is already some debate over which areas should be opened first, with manufacturing and transportation to be early candidates.  Schools, churches, and the like will probably come second.  A concern is a potential for the Coronavirus to flare up again, prompting a second lockdown.  It may be the second half or even 2021 before the economy and social life is restored.InflationThe most immediate effect of the Coronavirus is deflation, as lower demand responds to supply that has not adjusted.  A key example is the price of oil, where demand has dropped by over 10 million barrels per day, and almost all storage tanks are full. Yesterday the price of oil went negative, as owners of contracts could not find a place to accept delivery.  A contract is for 1,000 barrels, or 42,000 gallons.   Looking ahead, a resumption of normal activity should restore both demand and prices for oil.  In addition, higher wages and health insurance costs will drive the cost of services higher, and in time the cost of goods. Interest RatesOne of the great disservices by parts of the economics profession has been the idea that deficits do not matter in terms of a country’s finances.  This idea was first promulgated by John Maynard Keynes, who, to his credit, said that deficits in recessions needed to be paid off with surpluses in times of prosperity.From there, we had Arthur Laffer, whose curve was supposed to demonstrate that a country could grow by cutting taxes and without concern for deficits.  This was embraced as a tenant of Modern Portfolio Theory (MPT), which has driven so much of the financial market for the past decade. The trillions spent addressing the Coronavirus should help put MPT into the dustbin of history.  At some point, financial markets will demand higher interest rates to hold a security that there are so many of, even if the security in question is United States Treasury bonds and notes. The Stock MarketAfter riding along on a sea of cheap money, the stock market hit its own iceberg in February.  Since then, it has rolled over, retracing most of its decline.  It appears to be rolling over again. This is to be expected.  Usually, when a market drops as suddenly as this one has, some investors, using the peak as a reference point, “by on the dip.”  This creates the demand we have seen of late.  There is then a second decline that washes out those who ran into a burning building, so to speak.  From here, a base will be formed to lead the next advance. Recall that there is a one in five chance that the leaders of one market advance will lead the next.  This rotation of industries will need to be watched.Warren M. Barnett, CFA
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