Third Quarter Newsletter
“The market can stay irrational longer than you can stay solvent.” – Gary Schilling (attributed to John Maynard Keynes)
We continue to live in a world of two realities. After a plunge in real GDP at an annual rate of 32.9 percent in the second quarter, estimates for Q3 have risen steadily. The economy has been buoyed by an increase in the level of re-openings across the country, the promise of an accommodative Fed policy for years to come, and a decline in the number of new COVID cases. Initial jobless claims, which recorded 6.8 million in the week of March 27 at the peak of the crisis, are now hovering around 840 thousand. The Atlanta Fed’s GDPNow model estimates real GDP growth for Q3 2020 of over 35%. The stock market performance in the quarter reflects these trends. The S&P 500 index, which hit record highs in the beginning of September, ended the quarter up almost 9%, after a 20% return in Q2. Technology stocks similarly continued their rise, with Nasdaq 100 up over 12% for the quarter after a 30% rise in Q2.
Taking a step back, however, the situation still remains somewhat disconcerting. Initial jobless claims, despite the decline, are still in the top 0.1% readings of all time, after five months of re-openings. The New York Fed’s Weekly Economic Index — which is an index of ten indicators of real economic activity -– although significantly less negative, is still lower than it was at any time during the 2008/09 Great Recession. This quarter was the worst Q3 on record for bankruptcy filings, and there have been 193 bankruptcies year-to-date — most for any comparable prior period since the depths of the financial crisis (when there were 271). COVID-19 remains a concern, with the average increase in new cases in the US persisting at or above 40 thousand per day. The situation appears more dire in Europe, where COVID-19 cases in many countries have risen to levels last seen in March, and new restrictions are being imposed. The US is heading into an election that is fraught with the potential for legal uncertainty, judicial interpretation, and political gamesmanship. Meanwhile, the Shiller Cyclically Adjusted P/E (CAPE) multiple for the S&P 500 is around 30x ‘normalized’ earnings, which ranks amongst the third-most overvalued in history.
Market participants posit different theories to explain this dichotomy. Most cited are T.I.N.A (There Is No Alternative); the Fed’s policy of lower interest rates for longer, which increases the present value of future earnings; and a permanent shift in consumer behavior to a new work-from-home economy that will drive future growth for technology companies and justifies their lofty valuations. There is indeed a kernel of truth in all these arguments. However, it is hard to deny that the underlying technological shifts, although accelerated, existed before the crisis, and the liquidity provided by the Fed cannot continue in perpetuity without having meaningful adverse consequences (such as heightened inflation, devaluation of the dollar, and asset bubbles). Furthermore, although we remain hopeful of a peaceful election cycle, the potential for chaos is palpable.
In such an uncertain environment, it is imperative to maintain a disciplined approach to managing your assets and that is what we are committed to implement. At the end of last quarter, we had raised the possibility of using options as a means to provide downside protection in the event of a market correction. That is still a strategy we continue to evaluate. However, as the equity markets touched new highs, we felt that rebalancing your portfolios was the more optimal way to reduce some of the risk that we had added after the March downturn. We remain focused on investing in quality companies with sustainable long-term business models across various industries in a manner that provides diversification and balances growth with value. Our fixed income portfolios consist primarily of high investment grade bonds, and we are not in favor of stretching for yield as we do not believe that the so-called ‘high yield’ assets are appropriately priced on a risk-adjusted basis. We continue to maintain allocation to gold as a diversifier and a potential inflation hedge, and retain higher than normal cash balances that will allow us to play offense in the event of higher market volatility.
2020 has been quite eventful thus far, to say the least. It has tried our patience at times and has given us all much to reflect on. We at Cribstone appreciate you, our clients, for your partnership and support throughout this journey, and are always here for you to provide any help, guidance, or simply a friendly ear. Let’s hope for more peaceful and happy times as we head into the holiday season!
Scott Upham, CIMA® CPWA®
Contributions were made to this letter by Amyn Moolji, CIO and COO, Jeffrey Burch, and Taylor Haselgard.
Cribstone Capital Management (“CCM”) is an SEC-registered investment advisor located in the State of Maine. The firm and its representatives are in compliance with the current registration and notice filing requirements imposed upon SEC-registered investment advisors. CCM may only transact business in those states in which it is notice filed or qualifies for an exemption from notice filing requirements. For information pertaining to the registration status of the firm, please contact the SEC on its website at www.adviserinfo.sec.gov. A copy of the firm’s current written disclosure brochure discussing the firm’s business operation and fees is available from CCM upon request.